What is fiscal drag and how does it affect the taxes you pay?

The recent Budget was particularly impactful for business owners who must absorb higher national insurance costs from next April, as well as for wealthier families affected by a raft of measures around inheritance tax.

Given these relatively targeted measures, some may be thinking they weren’t really hit hard by the policies unveiled.

Yet there is a stealthy tax collector at large who will continue to take a progressively larger slice of almost every household’s income. Its name is ‘fiscal drag’.

What is fiscal drag?

Fiscal drag describes the scenario where the tax burden rises behind the scenes as incomes rise but tax bands don’t keep up or remain frozen. As income goes up, as inflation rises and pay increases, a larger proportion of earnings falls into higher tax bands. A person effectively gets taxed more on the same earnings in terms of its spending power.

Fiscal drag has sucked more and more people into paying the 40% higher rate of income tax over the years. According to the IFS in 1991/92 tax year, 3.5% of UK adults paid the 40% higher rate of income tax. By 2022–23, 11% were paying higher rates – four times the proportion.

Fiscal drag accelerated in recent years primarily owing to government efforts to balance the books from 2021following the COVID pandemic . Before then the thresholds would tend to rise with inflation each year. That meant that if your wages rose, you would need an above-inflation rise to be pushed into a higher tax band, or for more of your income to attract a higher rate. This meant that much of the fiscal drag effect was down to wages outpacing inflation. Today, though, the more pernicious effect is because the tax bands aren’t rising at all.

Income tax personal allowance and higher rate income tax threshold by tax year vs average earnings

Sources: HMRC, ONS

As the chart reflects, personal tax thresholds were frozen further into the future, until April 2028, by previous Chancellor Jeremy Hunt. However, inflation has ramped up since that time, and so have average wages for employees. As this trend continues, we will see greater numbers of middle-earners starting to pay higher-rate tax at the £50,270 level as time marches on and wages rise.

In addition, lots more people are paying tax for the first time as their income surpasses the still-frozen income tax personal allowance of £12,570. As things stand, there will be an extra 4 million taxpayers by 27/28 tax year.

Please note Scottish bands are different. The rates and bands referred to here are for the rest of the UK, but the same principle applies.

A small silver lining in the Budget was the announcement that income tax brackets will now not be frozen beyond 2028. From that point we can expect inflationary rises to resume. That’s a long way off mind, and its possible things change again before then – for the better or worse. Either way the Chancellor’s announcement around tax bands is not something that people will feel the benefit of in the short term because the tax burden will continue to rise between now and 2028.

What about savers and investors?

Income tax bands apply to interest on savings and income from investments too. Income from all sources is added up together to determine your overall tax rate. This means everyone is hit by frozen bands – pensioners for instance who have pension income plus investment income and interest on their cash.

What’s more, the additional allowances given to savers and investors have either been frozen too or they have been reduced – resulting in more fiscal drag, or even worse!

• The personal savings allowance remains £1,000 for basic rate taxpayers, £500 for higher rate tax payers, and zero for additional rate taxpayers.
• The starting rate for savings is frozen, a special 0% rate of income tax for savings income of up to £5,000 for those with taxable income below £17,570.
• The dividend allowance has been decimated in recent years. Having been reduced from £5,000 to £2,000 in 2017, and subsequently to £1,000 for the 2023/24 tax year, the allowance of £500 in the 2024/25 tax year is a shadow of its former self.

This all means lots of people are paying more tax on their dividends and savings interest to HMRC each year, especially given increases in interest rates. In addition, the capital gains tax allowance is still frozen at £3,000 following the Budget and the inheritance tax nil rate bands are also unchanged.

Will I pay tax on the State Pension?

The State Pension is another example of how fiscal drag can take bites out of people’s income.

In the Budget, a triple lock rise in the State Pension was rubber stamped at an inflation-busting 4.1% based on wage rises. A full New State Pension rises from £11,502 to £11,976 from next April.

This is now precariously close to the £12,570 income tax personal allowance where people start to pay income tax. As things stand it means a typical pensioner will start paying tax on the state pension alone in just threeyears’ time. The impact of this will depend on which element of the triple lock comes into play – wages, inflation or 2.5% – as the highest figure, and to what extent.

How can I beat fiscal drag?

If you are employed, a great way to counter fiscal drag is to make pension contributions. These receive pension tax relief, meaning you effectively claw back income tax. It means it only costs £80 to pay £100 into your pension for a basic rate taxpayer and £60 for a higher rate taxpayer.

To make things even more efficient consider making contributions via salary sacrifice if your employer allows it. This involves some of your salary going directly into your pension, with no tax deducted. Through this method you can save on national insurance as well as income tax, meaning it only costs £68 to pay £100 into your pension for a basic rate taxpayer, and £58 for a higher rate taxpayer.

Salary sacrifice is particularly useful for someone wanting to keep their earnings below the £50,270 higher rate level for instance, or the infamous £100,000 threshold where a 62% combined income tax and national insurance rate takes effect as the personal allowance is progressively withdrawn. The withdrawal of child benefit for those earning above £50,000 and of free childcare entitlement above £100,000 are also relevant to note.

For investments and savings, using an ISA can shelter your returns from the taxman and ensure you don’t pay unnecessary tax, and if you are a couple with different levels of income shifting cash or assets to the lower earner can also help minimise tax.

Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.