Fiscal drag shock: why it hits us harder than a 1% rise in income tax

Alice Guy explains what fiscal drag is, how it works and why it could raise more for the taxman than increasing income tax by 1%.

Who fancies a raise of 1% in income tax? I thought not! But what about fiscal drag: it’s doesn’t sound as bad, right?

Did you know that fiscal drag could actually cost us more in the long run than raising income tax by 1%?

In times of high inflation, fiscal drag is one of the main weapons available to the taxman.

Raising the headline rate of tax is deeply unpopular, resulting in terrible headlines, bad publicity and the inevitable pressure for the government to do a U-turn.

In contrast, fiscal drag is a subtle way of raising taxes, and is much less likely to meet widespread criticism.

Most of us know the headline rates of tax, but we don’t really look at how much tax we’re paying in total and if it has risen over time. 

How does fiscal drag work?

Fiscal drag works by keeping the tax thresholds the same year after year.

These tax thresholds are used to work out how much tax you pay.

In the UK, you currently pay 32% tax (20% income tax and 12% national insurance) on everything you earn over £12,570. The rates for Scotland are slightly different.

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Higher earners also pay 42% (40% income tax plus 2% national insurance) on earnings over £50,270.

There are also complicated rules for very high earners, who effectively pay 62% tax on earnings between £100,000 and £125,000.

There is also a 45% rate income tax on earnings over £150,000, soon to be reduced to £125,000 (still with 2% national insurance on top).

All income tax thresholds have been almost the same since 2019 and are due to remain the same until at least 2028 (the basic threshold rose a tiny £270 in 2021).

This means we’ll all be paying more and more tax each year, as tax thresholds remain the same for another six years, while our pay and everything else around us goes up with inflation.

A simple example

Here is simple example of why fiscal drag costs us more than we think.

In 2022, Peter earns £20,000 as a shop assistant. The tax threshold for income tax and national insurance means that he will pay 32% tax on £7,430 of his income. He will have a total tax bill of £2,499.

By 2028, his pay rises in line with inflation meaning Peter is now earning £24,823. He doesn’t feel any richer as his pay has just kept up with the cost of living. He now pays 32% tax on £12,253 of his income and has a total tax bill of £3,765.

In the six years between 2022 and 2028, Peter’s pay rises 22% but his tax bill climbs a staggering 51%. That difference is because Peter will pay income tax and national insurance on a much higher proportion of his income.

Fiscal drag affects all of us

Newspapers often talk about how many people will be dragged into the higher rate of income tax. But it’s important to remember that fiscal drag affects all of us, even if we don’t change tax band.

That’s because as our pay rises with inflation, more and more of our pay is taxed and our overall tax burden increases.

Very low earners and very high earners actually face even bigger tax rises than those on average incomes.

Bigger impact than raising income tax by 1%

As a tax geek I wanted to work out how much our tax burden would rise if the government increased income tax by 1% but, instead of keeping thresholds the same, tax thresholds carried on rising with inflation.

Raising income tax would be unpopular, but would we actually pay more tax than the current system: a system where tax thresholds are frozen but the rates of tax stay the same?

Would we be richer or poorer by 2028? Here are the results:

By 2028, someone earning £20,000 would be £1,185 poorer under the current “fiscal drag” system than if income tax was raised by 1%. It’s the same for high earners who will pay £1,474 more tax by 2028 under the current system, than with a 1% rise in income tax.

But it is top earners who would gain the most from a change in system. They would pay £9,780 less tax by 2028 if the thresholds were increased with inflation but income tax was raised by 1%.

Use your pension to save tax

If you can afford to, you can reduce your income tax burden by paying money into your pension. Pension savings are topped up by the taxman by at least 20%, meaning that it only costs a basic-rate taxpayer £80 to pay £100 into their pension.

• Learn more: What is a SIPP | ISA vs SIPP | SIPP Tax Relief Explained

If you’re a higher-rate taxpayer, you can get 40% tax relief for pension payments. Paying into a workplace pension means you’ll get 40% tax relief automatically, whereas, if you pay into a private pension, you’ll need to claim back the additional 20% through your tax return.