Financial inertia might result in millions of workers losing substantial amounts - understanding this concept and safeguarding your wealth becomes crucial. What exactly is fiscal drag, and how can you secure your finances?
Income Tax Thresholds Remain Frozen Until 2027/28
The income tax thresholds, last adjusted in the 2022 tax year, will remain unchanged until the 2027/28 tax year. This decision was first announced by then-Chancellor Rishi Sunak in the 2021 Budget, with current Chancellor, Jeremy Hunt, extending the freeze for an additional two years.
Millions of taxpayers in the UK could face increased tax bills as their income rises, while the tax-free personal allowance remains static. An analysis from Quilter, based on a Freedom of Information (FOI) request sent to HMRC, suggests that by 2027-28, as many as 17.9 million people could pay income tax for the first time, with 8.2 million over 60 paying tax on their pensions for the first time as well.
Fiscal drag is the term used to explain this scenario, where a higher number of taxpayers end up paying tax due to the government's decision not to adjust their income tax thresholds according to inflation and wage growth. This phenomenon will also lead to taxpayers paying more tax as their earnings increase.
According to the analysis, an additional 12 million people are expected to pay the higher rate of income tax (40% on income over £37,701 and below £125,140) by 2027/28. Moreover, two million more people will start paying the additional rate of income tax (45% on income over £125,140) in the same tax year.
Understanding Fiscal Drag
Fiscal drag occurs when a government fails to adjust income tax thresholds according to inflation and wage growth data. This means that the purchasing power of people's money does not increase at the same rate as their tax liability, causing them to pay tax despite not having an actual pay rise.
For example, when tax bands were frozen in Autumn 2022, the tax-free personal allowance was £12,570. According to the Bank of England's inflation calculator, £12,570 in 2022 is worth around £14,056 in March 2025, after adjusting for inflation. People today who earn the equivalent of £12,570 in 2022 (which is £14,056 in 2025) are now paying tax on the £1,486 difference due to inflation, even though they have not actually earned more money in real terms. Hence, fiscal drag can also be referred to as a 'stealth tax.'
Government's Justification for Tax Threshold Freeze
The decision to freeze tax thresholds was partly driven by the government's need to stabilize the country's finances following increased spending during the Covid-19 pandemic. Freezing tax bands was seen as a way to help balance the books and generate more cash during a critical time.
Politically, raising taxes can be a contentious issue, and freezing tax thresholds can be optically preferable as it does not appear to be an explicit tax rise. However, this approach is also the reason why many individuals and groups oppose the practice, labelling it a 'stealth tax.'
The Impact of Fiscal Drag
Fiscal drag affects more than just income tax. It could potentially lead to higher rates on dividend tax, capital gains tax, and a shrinking personal savings allowance.
To mitigate the impact of fiscal drag, individuals can consider strategies such as making the most of their ISA allowance, putting more into their pension, considering salary sacrifice, and carefully planning their income.
Make the Most of Your ISA Allowance
Using the ISA tax wrapper can help prevent your savings and investment income from pushing you over a tax threshold since any growth achieved in these accounts will not be taxed.
Plan Your Income
Carefully planning when your income enters your account can also help avoid the worst of fiscal drag. For example, you could opt for a fixed-term savings account that pays interest annually instead of an easy access option, which pays more frequently. You could then have the fixed savings interest pay out once you're in a lower tax bracket.
In conclusion, the impact of fiscal drag in the UK, due to frozen tax thresholds and rising inflation, is significant. Millions of taxpayers could face increased tax bills, and pensioners could be hit particularly hard. Employing strategies such as maximizing ISA allowances, pension contributions, salary sacrifice, and careful income planning can help mitigate the effects of fiscal drag to some extent.
- As the tax-free personal allowance remains unchanged, UK taxpayers could see a reduction in their personal savings due to higher tax bills, especially those with increasing incomes.
- The prolonged freeze on income tax thresholds could result in additional taxes being levied on pensions, affecting millions of retirees who might be taxed on their pensions for the first time by 2027/28, potentially impacting their personal finance and retirement savings.
