The Bank of England has a single tool to manage inflation: interest rates. When inflation rises above target, the Bank raises rates, making borrowing more expensive and saving more attractive. When inflation falls, it cuts rates to encourage borrowing and spending. For 25 years, this blunt instrument worked adequately. In an era of energy shocks, supply-chain disruptions, and pandemic-induced stagflation, it has become inadequate.
The problem is that interest rates conflate demand-side and supply-side inflation. When inflation is driven by too much money chasing too few goods — demand exceeds supply — higher rates work by dampening demand. Consumers borrow less, businesses invest less, spending falls, and inflation eases. But when inflation is driven by supply shocks — energy prices surge, supply chains break, oil prices spike — higher rates do not address the underlying problem. They simply make borrowing more expensive for everyone. Businesses cannot raise production if inputs are unavailable. Consumers cannot reduce their demand for heating fuel when winter arrives. Raising rates punishes both anyway.
The inflation experienced in 2021-2023 was dominated by supply shocks: energy prices trebled, semiconductor shortages constrained manufacturing, shipping costs spiked, and labour shortages drove wage growth. The Bank of England raised rates from 0.1 per cent to 5.25 per cent — a 50-fold increase — yet inflation proved sticky. Why? Because the dominant drivers were supply constraints, not excessive demand. Raising rates reduced demand growth and slowed inflation’s rise, but could not solve supply-driven inflation. Only supply expansion — energy production ramping up, supply chains normalizing, semiconductor fabrication increasing — could solve the underlying problem.
The limitations of the current framework
Interest rates work through a long transmission mechanism. The Bank raises the base rate. Banks gradually increase mortgage rates and loan rates. Households and businesses observe higher borrowing costs and adjust behaviour over months. Demand gradually falls. Inflation gradually responds. The lag is 12 to 18 months for full effect. This lag is problematic in two ways. First, policy can overshoot — by the time higher rates bite demand, the initial shock may have reversed, driving inflation down further and creating deflationary pressure. Second, policy mistakes become very costly because they persist through the long lag.
Moreover, interest rate increases distribute pain asymmetrically. Banks and savers benefit from higher rates; borrowers suffer. Overseas investors benefit; domestic businesses suffer. Those who own assets benefit; those who need credit suffer. This is not a normative concern — it is a technical observation. Interest rate policy is not neutral; it redistributes wealth. For inflation control, this is often unavoidable, but it creates powerful political constituencies opposed to rate increases and puts pressure on the Bank to moderate tightening even when inflation control requires it.
Supply-driven inflation, by definition, cannot be solved by demand destruction. Yet demand destruction is all that interest rates can deliver. This creates a bind: inflation persists despite very high rates, populations suffer through both high inflation and high unemployment, and central banks are blamed for policies that were never adequately suited to the problem in the first place.
The proposal is radical but straightforward: give the Bank of England a second tool — variable PAYE — that allows it to adjust demand through the tax system rather than through interest rates. When inflation is high, the Bank increases the amount withheld from worker pay packets, reducing disposable income and dampening demand. As inflation falls, the Bank reduces withholding, releasing money back to workers and stimulating demand. The bandwidth is ±2 percentage points above the standard PAYE rate. The effect is felt within one pay cycle — roughly two weeks.
How variable PAYE would work
PAYE (Pay As You Earn) is already a system where employers withhold income tax from worker pay packets. The rate is currently standardized and determined by Parliament. The proposal is to allow the Bank of England to adjust this rate within a narrow bandwidth — say, standard PAYE ±2 percentage points — based on inflation targets and labour market conditions. When inflation rises above 2 per cent, the Bank can increase PAYE withholding by up to 2 percentage points. When inflation falls significantly below target, the Bank can reduce PAYE withholding by up to 2 percentage points.
The mechanism is administratively trivial. PAYE rates are already set centrally; employers are accustomed to adjusting them. A change in PAYE codes affects payroll systems but requires no legislative change to individual tax codes or benefits. Employees see the adjustment in their next pay packet — roughly one-to-two weeks. The effect on demand is immediate. Workers with less take-home pay reduce spending. Workers with more take-home pay increase spending.
The advantage over VAT adjustment (which is sometimes proposed as an alternative tool) is precision and distribution. VAT increases hit all consumers equally and affect the poorest hardest, since they spend a larger share of income on consumption. PAYE adjustment affects workers disproportionately and is progressive — higher earners see larger absolute changes because they pay more tax. Moreover, VAT changes require legislation; PAYE adjustments within the agreed bandwidth require only Bank technical action.
| Tool | Speed | Distributional effect | Implementation |
|---|---|---|---|
| Interest rates | 12-18 months | Asymmetric (savers benefit) | Automatic |
| Variable PAYE | 1-2 weeks | Progressive (workers affected) | Administrative |
| VAT adjustment | Weeks (legislative) | Regressive (poor hit hardest) | Legislative |
Monetary policy is not well-suited to deal with supply-driven inflation. A second tool would give central banks precision to target demand-side pressures without destroying supply-side activity.
Martin Beck, citing Stiglitz on monetary policy
Why this preserves Bank independence
The critical objection to variable PAYE is that it compromises central bank independence. If the government can adjust PAYE, and the Bank can adjust PAYE, has the Bank truly lost autonomy? The answer depends on how the framework is structured. The CRPF proposes that variable PAYE operates identically to the base rate: the Bank sets the rate within a clearly defined bandwidth (±2 per cent), Parliament cannot override this setting, and the Bank is accountable for outcomes but not for the specific decisions.
In fact, giving the Bank a second tool enhances its independence. Currently, interest rates are the only lever, and the Bank faces intense political pressure to keep rates low because high rates are unpopular. By introducing variable PAYE, the Bank gains flexibility to hit inflation targets through multiple mechanisms. In some scenarios, it raises rates and adjusts PAYE downward to offset the distributional effects. In others, it maintains rates and adjusts PAYE upward to address demand-driven inflation without penalizing savers. The toolkit expands; the independence is preserved.
Operationally, the Bank already has the administrative infrastructure to manage PAYE adjustment. The Office for National Statistics, working with HMRC and employer payroll systems, can implement and monitor changes. The Bank would publish its PAYE adjustment decisions alongside interest rate decisions in its Monetary Policy Committee statement, providing full transparency and accountability.
The critical risk: government temptation
This is where the author must be entirely candid. Variable PAYE works if the Bank is truly independent and sets rates based on inflation targets. It fails spectacularly if government discovers that it can control PAYE adjustment to boost spending during election cycles. If PAYE becomes a tool of political management rather than inflation control, workers face constantly fluctuating take-home pay, businesses face unpredictable consumer spending, and the entire system collapses into farce.
The risk is not theoretical. Governments have repeatedly politicized central banking. The US Treasury has pressured the Federal Reserve. The ECB has faced political pressure from governments over interest rates. A variable PAYE system requires ironclad safeguards: the Bank must have sole control over PAYE adjustment, operating within a clearly defined bandwidth; Parliament must not be able to override decisions; the framework must survive political cycles; and the Bank must be transparent about its methodology so that deviations from inflation targets are immediately apparent.
For this reason, the CRPF proposes variable PAYE not as an immediate implementation but as a pilot. The first phase involves a careful test in a simulated environment: what happens to inflation and labour supply if PAYE adjusts within a narrow bandwidth during a period of stable prices? How do workers and businesses respond? Are behavioural effects as expected, or do surprises emerge? Only after this pilot, with demonstrated safeguards and proven effectiveness, should variable PAYE be operationalized.
Moreover, variable PAYE should never be introduced without corresponding spending discipline. The policy works only if government commits to controlling spending growth, preventing the situation where government is cutting taxes (through lower PAYE withholding) while simultaneously running large deficits. If government is committed to full employment and unlimited spending, variable PAYE becomes a tool for extracting value from workers in real terms rather than for inflation control. The proposal must be embedded in a broader package that prioritizes fiscal discipline and growth.
The intellectual case
This is, admittedly, a maverick idea that steps well outside the comfort zone of orthodox monetary policy. Central bankers and economists will correctly identify serious risks and implementation challenges. The author welcomes this scrutiny. A proposal this novel requires rigorous testing, not naive implementation.
Yet the intellectual foundation is sound. When demand exceeds supply, reducing demand-side purchasing power is more efficient than making all borrowing more expensive. When inflation is driven by supply shocks, a second tool provides optionality that interest rates alone cannot deliver. When transmission lags are long, a tool with short transmission lags provides precision. And when one constituency (savers) gains from high rates and another (borrowers) loses, a tool that affects labour income provides a different distribution of effects.
Maverick ideas should not be dismissed before they are understood. This is not a perfect solution; it is a better one than the current single-tool regime.
Martin Beck, Mortgaged to the Hilt
The comparative experience is instructive. Japan’s central bank has experimented with yield curve control and unconventional tools when traditional interest rates approached zero. The ECB has deployed quantitative easing when interest rates alone proved inadequate. Central banks, faced with problems beyond the scope of their traditional tools, have innovated. Variable PAYE is a domestically-focused innovation that operates in a more conventional space: tax withholding is already a central government function. Making it responsive to inflation targets, within safeguards, is not revolutionary; it is evolutionary.
The preconditions
Variable PAYE cannot work in isolation. It must be part of a package that achieves spending control, grows the economy, and maintains price stability. That package includes: pension reform to slow long-term spending growth; welfare modernization to improve work incentives; tax cuts that stimulate investment and work; and infrastructure investment that expands supply. Variable PAYE is a tool, not a strategy. It works only when paired with a growth strategy that addresses supply constraints and a fiscal strategy that achieves discipline.
The proposal also assumes that inflation targets remain anchored. If central banks abandon the 2 per cent target and instead tolerate 5-6 per cent inflation as acceptable, variable PAYE would simply become a tool for managing this higher baseline. The focus must remain on bringing inflation back to target, stabilizing expectations, and maintaining the credibility that allows central banks to operate with independence. If that credibility erodes, no tool can substitute for it.
Finally, variable PAYE should not be introduced without careful pilot testing and international consultation. The Bank of England does not operate in isolation; its decisions affect sterling exchange rates, capital flows, and global financial stability. Any innovation in monetary tools must be understood by other central banks and financial markets. Transparency, testing, and consultation should precede implementation.