What is fiscal drag?
Fiscal drag is the effect that the freeze on income tax rates and bands has on real earnings.
When tax bands or tax allowances do not rise along with inflation or the cost of living, you may find that you inadvertently pay more income tax.
This happens when more people earn higher wages, such as during times of inflation, when wages rise to meet a higher cost of living.
In real money terms, the effect on affordability is nil – higher wages meet a higher cost to live – but unchanged tax bands or tax allowances mean more people are pushed into higher tax brackets.
For this reason, fiscal drag is also known as a ‘stealth tax’. Although income tax rates have not officially changed, tax revenues still rise.
For example: child benefit decreases
Your salary increases to £51,000. The child benefit allowance is still £50,000, so you have to repay 10% of the benefit you received to HMRC.
The following year, another salary increase to £53,000 means you repay 30%, and at £60,000, you repay all of the child benefit you receive.
In addition, tax thresholds have not increased, so you also pay more tax, as a greater proportion of your salary now falls into a higher tax band.
For Example: 60% tax rate
Your salary increases to £126,000.
The personal allowance (PA) ceiling is still £100,000 and reduces by £1,000 for every £2,000 over £100k adjusted income you earn.
As a result, you lose entitlement to the entire PA of £12,570 (the proportion of your income you can earn tax-free).
In effect, the loss of the PA means your earnings above £100k will now be taxed at a rate of 60%.
This position is even worse if you are a Scottish taxpayer, as you would have an effective tax rate of 63%.
3 tips to beat the effects of fiscal drag:
1. Know how much tax you are paying
Look at your income and know how much of your earnings are going into each tax bracket.
2. Reduce your taxable earnings
If affordable, reduce your taxable earnings by paying into pensions or to charity. Pension contributions have a double-positive tax effect (relief on contributions increases the amount paid in, while reducing your income tax), but can affect means-tested affordability, such as for mortgages.
3. Talk to an expert
We can help you to structure finances and investment products, and extract business profits, in a way that’s as tax efficient as possible for you.
Tax and legislation is complex and should always be considered carefully, talking all your details into account.
To find out more, please contact us for an introductory discussion with our expert team.
Content on this page is provided for general information and is subject to change and does not constitute advice.
If you would like to know more for your own situation, please do not hesitate to contact us.
We would be delighted to discuss this with you in more detail, taking your circumstances into account.
