Recent figures from HMRC show that compared with three years ago there are now 4.2 million more workers paying income tax of 20% and 1.6 million more people are now in the 40% bracket. Why? It is because tax thresholds were frozen in 2021 and it is all down to ‘fiscal drag’.
What is fiscal drag and how has it happened?
Tax allowances normally rise in line with inflation, but they were frozen by Rishi Sunak in 2021 when he was Chancellor. Originally the freeze was estimated to raise £8bn a year by the end of the parliament and scheduled to last until 2026.
Jeremy Hunt has since extended the freeze until 2028 and widened it to include national insurance contribution thresholds.
However, soaring inflation since then has seen tax income from the policy surge and the current estimate is that fiscal drag will raise over £25 billion a year in 2027/28 according to a recent report in The Times.
Wages for many rise each year to keep up with inflation and according to the Office for National Statistics wage growth is currently 8.5%.
Unless tax bands rise accordingly then workers may find themselves in a higher tax band than previously or beginning to pay income tax for the first time.
This is known as fiscal drag because it ‘drags’ you into a higher tax bracket. You’ve probably also heard it called a ‘stealth tax’.
Inheritance tax (IHT) threshold also frozen until 2027-28
Just as increasing salaries drag workers into a higher income tax band, assets such as property also rise over time. So, more people are likely to get dragged into paying IHT as a result of this.
Why is stealth tax good for Government?
The Government will be in favour of these stealth taxes because they raise significant amounts of money which is desperately needed to pay off public debt.
As the freezes on tax thresholds will continue until 2028, millions more of will be paying more tax and according to research by the Institute for Fiscal Studies, a fifth of workers will be paying the 40% rate by 2027. IHT could raise as much as £8.4 billion by 2027/28, according to estimates from the OBR.
How will fiscal drag affect my finances?
Simply, depending on your wage growth over the next four years, you may end up paying more income tax. If you inherit a property or leave a property as part of your estate, then you might well be looking at IHT.
Can I do anything to mitigate the impact of fiscal drag?
There are some actions you might want to consider.
If you’re self-employed make sure you claim all your expenses
If you’re self-employed, you can reduce your tax bill by deducting allowable expenses against your income. HMRC provides lots of information online covering what expenses are allowable.
Increase your pension contributions
Whilst this might leave you with less in your pay packet you might be able to avoid 40% tax.
Look at your savings
Whilst savings are great, they can mean that you end up paying more tax. Make the most of your ISA allowances for savings where interest and investment growth are tax free.
Charitable giving
Giving money to charity can reduce your tax bill. For every £1 you donate under Gift Aid the charity can reclaim an extra 25p. Higher rate taxpayers can also reclaim the difference between tax they’ve paid on the donation and the amount the charity reclaimed.
Going forward
There is a lot of uncertainty at the moment! There is the Autumn Statement next week and undoubtedly a general election next year so everything might change.
As always, we will be keeping you informed and giving you our thoughts.
Get in touch if you need any advice.
Disclaimer
The information was correct at time of publishing but may now be out of date.
