Beware of Brown's taxation by stealth

Conflict in Iraq and market uncertainty may force the Chancellor to be more brutal in his Budget on Wednesday, says William Kay. He's got a £20bn shortfall to fill

Gordon Brown had good reason to hope the Iraq conflict would be over by the time he unwrapped this year's Budget on Wednesday. But that hope has been replaced by fear among millions of people that the war, falling stock market and slowing economic activity will force the Chancellor to impose steep increases in tax and national insurance contributions, or Nics.

Had the war been over by now, Mr Brown could have based his Budget on sensible calculations about the cost of the British military effort, and the economic outlook would have been clearer. As it is, he will have to set aside an open-ended sum to support the troops and it is becoming increasingly difficult to gauge how far he will be dragged down by uncertainty and the consequence incentive to postpone decisions.

The "put-it-off" factor is already having a deadening impact on housing and financial services. The latest Halifax and Nationwide house-price surveys show a slower rate of increase. Bank of England figures this week also showed mortgage growth slowed in February, and Simon Holdsworth, of Towry Law Mortgage Services, said much of the business was remortgaging on low interest rates. And today marks the end of what will undoubtedly be the worst Isa season on record.

All these trends spell lower tax revenues for the Treasury, in Vat, stamp duty, capital gains tax and income tax. Economists reckon Mr Brown will have to fill a £20bn hole in the public finances, through borrowing or tax.

John Whiting, tax partner at the accountancy firm of PricewaterhouseCooper, said: "The Chancellor will need fancy footwork to convince the City the medium-term outlook for the public finances is still consistent with his 'golden rule' of borrowing only to invest over the course of the economic cycle.

"Last year he took action earlier than he needed to in signalling that taxes would rise significantly from this April. He may need to admit taxes may have to rise again to fund his longer-term spending plans, unless the economy rebounds more rapidly than most pundits expect."

But Mr Whiting adds: "The chances are that there will be no significant tax rises in the 2003 Budget. It seems too early after the 2002 rises – which do not come into play until 2003 – to raise taxes again. To do so would smack of incorrect forecasting last year and even a measure of panic, the last thing the Chancellor would want to give an impression of. This is not to say there won't be more stealthy tax rises."

His top tip is to leave unchanged the starting point for various taxes, instead of raising those thresholds in line with inflation, the trick known as "fiscal drag". The Chancellor has already announced this will apply to several taxes and Nics.

The personal allowance, the point at which income becomes taxable, of £4,615 for under-65s will not be increased, raising £600m. Mr Whiting's favourite is to hold the start of the higher 40 per cent income tax rate at £35,115.

Even in this low-inflation era, if the starting point is held, more people will be sucked into the top rate through pay rises. Accountants KPMG reckon this will raise £380m.

Last year, the Chancellor said everyone earning more than £89 a week would have to pay 11 per cent in Nics instead of 10 per cent. As if that were not bad enough, the starting point will not increase from £89 in the tax year which has just begun, and will remain at £89 in 2003/04. But the upper limit has been increased from £585 per week to £595 for the new tax year, equal to lifting the threshold from £29,900 a year to £30,420.

Stephen Herring, of the accountants BDO Stoy Hayward, believes the Chancellor could bring the Nics earnings threshold in line with the effective income-tax threshold, which would mean those earning more than £34,515 would pay about £350 more each year in Nics. That would bring Mr Brown £1bn a year.

With something like that under his belt, he may index the present £7,700 of profits exempt from capital gains tax to £7,900, and the inheritance tax threshold should rise from £250,000 to £255,000. But, with house prices up 25 per cent in the past year, that will still snare many people's homes.

Philippa Gee, of the Midlands IFA Torquil Clark, said: "The Chancellor should either raise the threshold substantially or, as with capital gains tax, exclude main residences."

But there is a large inheritance tax loophole Mr Brown may close. Julia Richards, at KPMG, says they expect legislation that allowed individuals to create trusts which benefited them free of inheritance tax to be reversed.

Savers could also be hit. KPMG expects a decision to stop letting insurance policyholders withdraw 5 per cent of the value of their policies tax-free each year, the so-called drawdown.

And it will be a surprise if Mr Brown relents on his intention from next year to prevent investment funds recovering the 10 per cent tax credit on dividends within Isas. The other looming Isa catch is to cut the £7,000 maximum annual contribution to an Isa to £5,000 after 5 April, 2006. Mr Brown could waive this, but don't hold your breath.

And if you are inclined to drown or smoke your sorrows away, this might be the time to stock up. The accountant Deloitte & Touche said alcohol and tobacco duties have been frozen but they are traditionally easy targets because they raise tax revenue efficiently and the Chancellor can say he is doing his bit to cut hospital waiting lists.

And if you have been salting money illicitly in offshore accounts to keep it from Mr Brown's prying eyes, you may find him offering you an amnesty: come clean and the Inland Revenue will say nothing about the tax you have dodged so far.

This has worked well for the German and Italian tax authorities, to the chagrin of Swiss banks which made vast profits out of sheltering such money. It could be as generous as Mr Brown gets next week.

'I had a pay rise but we're no better off'

Marc Doyle is a Labour supporter who feels he has had a raw deal from the Chancellor, despite being a teacher at a school being upgraded with Government money. "I would describe myself as being reasonably comfortably middle-class, I'm quite confident in Tony Blair and I think Gordon Brown is extremely prudent, but I'm worried by him."

Mr Doyle, 31, is head of maths at Thornhill High School in Dewsbury, West Yorkshire, his wife Sally, 34, is a medical secretary and they have two children, Eve, four, and Ami, two. "Sally and I should both benefit from the government's commitment to hospitals and schools," he said. "But while there have been a lot of initiatives the main problem is teachers' pay, which is too low to enable us to recruit and retain the right people."

The Doyles have a £90,000 discounted repayment mortgage, so they are concerned about increased interest rates. They will collect the new child tax credit, but Mr Doyle thinks it may not be enough to make up for losing the old credit.

"And our council tax has also gone from £700 to £850 which is good value because Barnsley council has been spending on redeveloping the town centre and more police," Mr Doyle said. "But, with that and higher national insurance contributions, we are definitely out of pocket. I've had a 2.9 per cent pay rise this year, but when you take account of the higher outgoings we're no better off."