What is fiscal drag and how does it impact my tax bill?
We have all read the headlines on UK taxpayers paying the highest rate of tax for decades, due to the fiscal drag or stealth tax. But what is fiscal drag, and how does it impact your tax bill?
What is fiscal drag?
Fiscal drag is usually discussed when considering the freezing of tax free allowances before tax kicks. The personal allowance, or the income each individual in the UK can earn in a tax year before you need to pay tax, was last increased in April 2022, when it rose marginally from £12,500 to £12,570. However, the year before it was announced that there would be no more increases to your tax free income until at least 2025/26. Jeremy Hunt, the Chancellor, then extended this to April 2028 at the Autumn Statement in 2022.
The reasoning? To help the country balance the books after the COVID pandemic. The impact? More of our income is now taxed, less of our income is tax-free.
By freezing the personal allowance and certain tax thresholds, your income slowly erodes as inflation rises. Usually, the default approach is to increase tax allowances annually based on inflation, called ‘uprating’, so your income keeps up with the cost of increased prices of goods and services.
Am I impacted by fiscal drag?
When thinking about fiscal drag, you are looking at the effect of freezing tax allowances and more of your income being taxed as a result at higher rates of income tax. The logic is that as wages rise over time, while rates are frozen, more people will start to earn more than their personal allowance and come into the basic tax band, while others are ‘dragged’ into higher rate taxes.
And even if you do not cross from the basic to the higher rate of income tax in a given tax year, you are still impacted by fiscal drag when the income tax thresholds are frozen.
For example, for someone earning £35,000 in the current tax year, the approximate tax you will pay is £4,486, around 12.8%. If you then get a salary increase to £37,100, although you are still paying the basic rate of income tax, the percentage of tax you are paying on your income rises to 13.2%, or £4,906.
What does fiscal drag mean for my income?
If the freezing of tax free thresholds does indeed continue as planned until April 2028, more of us will feel the chill of less money in our pockets.
According to the OBR. 4 million additional individuals will be start to pay tax and another 3 million will move into a higher rate of income tax.
The fact that inflation and interest rates have increased dramatically in recent times and both remain high, the number of people being impacted by fiscal drag is growing at a faster rate.
What can I do to help mitigate the impact of fiscal drag?
There are a few tax reliefs available you can use before your income starts to be taxed. Pension contributions, charity donations, and some employee benefits can be used to help your overall tax burden, but usually in the context of ensuring you do not breach an income tax threshold, for example paying into your pension to keep you at the basic rate or below the higher rate of income tax.
