Inflation drop answers question on state pension but raises another

UK inflation has finally eased below the Bank of England’s 2% target, a significant milestone in the country’s long-running battle to keep price rises in check.

The Consumer Prices Index (CPI) cooled from 2.2% to 1.7% in the year to September 2024, its lowest level for three years, coming in 0.2 percentage points under expectations.

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And there was encouraging news across other inflation metrics. Core inflation - which strips out energy, food, alcohol and tobacco - eased to 3.2% in the 12 months to September, versus 3.6% in August. Elsewhere, services inflation, which has proved particularly sticky in recent times, cooled from 5.6% to 4.9%.

This is a significant development and may pave the way for back-to-back interest rate cuts in November and December.

Money markets now reckon there’s a 91% chance the Bank Rate will reduce by 0.25 percentage points next month – up from 80%. Earlier this month, Bank Governor Andrew Bailey indicated that the Monetary Policy Committee (MPC), the rate-setters, may cut rates a bit more aggressively if inflation continues to ease.

September’s inflation data also has relevance to the state pension, as it can influence how much the policy rises every year. Today’s news helps us answer one key question about the policy’s future but raises another important one. Let’s take a look at those.

Question answered: April’s state pension increase confirmed

The state pension rises every year by the highest of three metrics, which are inflation, average wage growth and 2.5%. This is known as the triple lock.

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When calculating the inflation increase, the 12-month figure to September is used, while for earnings it’s the three-month data between April and June.

With the annual inflation figure now confirmed, we now know that the state pension will rise by average wage growth from April 2025, which came in at a solid 4.1%. Retirees received a slight boost yesterday after it was revealed the Office for National Statistics (ONS) revised up the three-month earnings data from 4%.

This means the full state pension will receive a bumper £473 uptick from April 2025, taking it to £11,975 a year, while the basic state pension will increase by £361 to £9,175. Not only will this provide pensioners with an inflation-beating increase but may bring at least some comfort to those who’ll no longer receive winter fuel payments.

The triple lock has been subject to constant scrutiny in recent years. Critics have claimed the policy should be scrapped as it’s too expensive. The Institute for Fiscal Studies (IFS) in December 2023 argued the policy should be replaced with a double lock, with the inflation element removed.

However, Labour has repeatedly stressed it will keep the triple lock, so we can expect the 4.1% state pension hike to be rubber stamped by Chancellor Rachel Reeves at the Budget in two weeks’ time.

Question raised: Should the government increase tax thresholds?

In its election manifesto, Labour pledged to keep tax thresholds at their current levels until 2028.

This is a rather stealthy tax-raising tactic known as fiscal drag, which occurs when a combination of frozen tax thresholds and rising incomes (or asset prices) force more people into higher rates of tax.

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With the personal allowance, the amount of income you can receive every year tax free, maintained at £12,570 since 2021, the state pension is catching up fast. In absence of change, the state pension could become taxable in as soon as two years’ time.

The table below shows the relationship between the personal allowance and the state pension since the 2016-17 tax year, and what it’s set to mean from April 2025.

Source: gov.uk

The widest margin occurred in 2019-20, when it stood at £3,732. However, in the preceding years, the gap has dwindled. From April, it could be just £595, meaning a larger portion of other retirement income, such as drawdown withdrawals, annuity payments, and buy-to-let property rents, will be subject to tax.

Analysis by the House of Commons for the Liberal Democrats conducted in Spring 2024, calculated that an extra 1.6 million pensioners’ incomes will trip above the personal allowance in the next four years.

The generosity of the triple lock is playing a key role here, of course. Pensioners have enjoyed bumper annual increases of 10.1% and 8.5% in recent years. That said, one can make a solid argument that these were necessary to protect retirees’ incomes from the harshest cost-of-living crisis in 40 years.

Indeed, the decision to freeze tax thresholds is affecting workers, too. But April’s expected state pension increase will put more pressure on the government to reverse its position here to avoid the full rate exceeding the personal allowance.

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The problem Reeves faces is that fiscal drag is lucrative for the Treasury. According to a briefing in the House of Commons library, published in August 2024, freezing income tax thresholds is forecast to raise £33.5 billion in 2028-29. To put this into context, that’s almost twice as much as the government currently collects in annual capital gains tax (CGT) receipts.

But making the right calls on difficult and crucial decisions such as changes to tax bands are where chancellors of the exchequer earn their stripes.

Given the country’s well-documented bleak fiscal position, I very much doubt thresholds will tick up from next April. But the pressure on Reeves to act here, for both pensioners and the working population, will intensify at every future Budget.