You are here: Home - Saving-Banking - News - Understanding -

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

Written by: Freddie Cleworth
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  • The £100,000 income limit at which the personal allowance starts to be withdrawn is unchanged since it was first introduced in 2010.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

There are 0 Comment(s)

If you wish to comment without signing in, click your cursor in the top box and tick the 'Sign in as a guest' box at the bottom.

Your right to a refund if travel is affected by train strikes

There have been a wave of train strikes in the past six months, and for anyone travelling today Friday 3 Febru...

Could you save money with a social broadband tariff?

Two-thirds of low-income households are unaware they could be saving on broadband, according to Uswitch.

How to help others and donate to food banks this winter

This winter is expected to be the most challenging yet for the food bank network as soaring costs push more pe...

What will happen if rates change

How your finances will be impacted by a rise in interest rates.

Regular Savings Calculator

Small regular contributions can build up nicely over time.

Online Savings Calculator

Work out how your online savings can build over time.

DIY investors: 10 common mistakes to avoid

For those without the help and experience of an adviser, here are 10 common DIY investor mistakes to avoid.

Mortgage down-valuations: Tips to avoid pulling out of a house sale

Down-valuations are on the rise. So, what does it mean for home buyers, and what can you do?

Five tips for surviving a bear market mauling

The S&P 500 has slipped into bear market territory and for UK investors, the FTSE 250 is also on the edge. Her...

Money Tips of the Week