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What is ‘fiscal drag’ and how does it affect you?

Paloma Kubiak
Written By:
Paloma Kubiak

In a perfect example of ‘fiscal drag’, the Chancellor recently announced that both the personal allowance and the higher rate threshold would be frozen for an additional two years.

Fiscal drag is the stealthy way in which Governments pull more and more taxpayers into higher tax brackets without the backlash that comes with increased tax rates.

In his recent Autumn Statement, the Chancellor Jeremy Hunt announced that both the personal allowance and the higher rate threshold would be frozen for an additional two years, up to April 2028.

The Office for Budget Responsibility (OBR) estimates this policy will result in 3.2 million more people paying income tax, and 2.6 million more people being brought into the higher rate band – raising £26bn per year by 2027/28.

Income tax thresholds

The personal allowance (£12,570) and the basic rate tax threshold (£37,700) are unchanged since 2021/22, and, like the Inheritance Tax (IHT) nil rate band, are now set to remain frozen until 2028. Other thresholds are subject to fiscal drag because the Government overlooks them year after year:

  • The £100,000 income limit at which the personal allowance starts to be withdrawn is unchanged since it was first introduced in 2010. Personal allowance withdrawal leads to a 60% marginal tax rate, and an estimated one million more taxpayers could be caught if nothing changes over the next five years.
  • The High Income Child Benefit Charge income limit of £50,000 is unchanged since its introduction in 2013. Around one in five families are now affected by the limit, compared to one in eight when the charge was first introduced.

To mitigate the impact of these frozen thresholds, some income tax planning may be possible for spouses and civil partners.

Inheritance tax

One of the starkest examples of fiscal drag is the freezing of the IHT nil rate band that has been set at £325,000 since April 2009. Combined with soaring property prices, it is no surprise the Government’s IHT receipts have nearly doubled in the ten years to 2021/22, with current year receipts set to see a further significant increase.

The nil rate band had previously been frozen at £325,000 until 2026, but the Autumn Statement has now extended the freeze until 2028.

IHT bills can sometimes be mitigated with careful lifetime planning, although people should be careful not to leave themselves short of funds later in life.

Pension Lifetime Allowance (LTA)

The LTA, which governs how much can be saved in a pension before a Lifetime Allowance tax charge applies, remains at its current level of £1.073m until 2025/26. This effectively sets the maximum tax efficient value of all your retirement benefits, assuming you have not already applied for any of the protections that are available.

If your accumulated pension benefits exceed the LTA there is a tax charge which is 25% if the excess is drawn as taxable income and 55% if it is received as a lump sum.

How to reduce the impact of fiscal drag

You can start by maximising your annual tax-free individual savings account (ISA) allowance of £20,000, and any pension allowance.

Aside from making full use of available allowances and reliefs, there are many other advantages to planning ahead. Making the most of yours and your family’s pension allowances can help dedicate funds to grow for financial independence, while also providing useful income tax-relief.

Some individuals may be able to carry forward previous years’ unused pension allowances too, providing further potential to reduce income tax liability.

Freddie Cleworth is chartered wealth manager at EQ Investors