After Wednesday’s Budget, the chancellor Rachel Reeves is keen to point out that she hasn’t raised taxes for working people, but if you look at the figures, we’re all gradually paying more tax due to the government’s clever use of fiscal drag.
It all began back in 2021 when the Conservative Party froze the thresholds at which you start paying basic-rate and higher-rate income tax. In doing so, the Treasury found a way to increase its revenue, as higher wages and inflation bring more taxpayers over those thresholds.
Up until this week, the thresholds were set to be frozen until 2028. The Budget saw that timeframe extended to 2031.
“It’s quite the U-turn for Reeves, who in opposition claimed that the policy was ‘picking the pocket’ of working people,” says Laura Suter, director of personal finance at AJ Bell.
But when you start taking a closer look at the figures, it is an obvious way for Reeves to dramatically increase tax revenue while also being able to argue that she hasn’t raised tax rates.
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According to the Office for Budget Responsibility (OBR), by extending the freeze, the Treasury should gain £12bn by 2031. It also estimates that the freeze will cost each of us around £1,330 a year by 2029.
“While it’s a nifty way for the government to raise money, the cumulative effect of the freeze means people are seeing their tax bills rise dramatically when compared to a system in which thresholds had increased by inflation each year,” says Suter.
What is fiscal drag?
Fiscal drag is where, thanks to a lock being placed on the amount you can earn before you pay basic and higher-rate income tax, workers are dragged into higher tax brackets.
The personal allowance – how much you can earn before you pay the basic 20 per cent rate of income tax – has been stuck at £12,570 since 2021. So, more people have been subject to income tax as wage inflation has taken them over the threshold. The OBR predicts that 5.2 million people will become taxpayers between 2022 and 2031 thanks to the frozen threshold.
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The amount you can earn before you pay higher-rate income tax – where your income-tax rate becomes 40 per cent – has been £50, 270 for four years. Since 2021, more than 8.3 million people have become higher or additional-rate taxpayers. That is an increase of 45 per cent, according to figures from AJ Bell.
“The tax freeze has dragged almost three times more people into the higher-rate band than was originally expected,” says Suter. The OBR initially predicted that the freeze would create a million more higher-rate taxpayers. There are now 2.7 million more people paying the 40 per cent rate, and that is expected to grow to 4.8 million by 2030-31.
What is fiscal drag costing you?
The impact of fiscal drag on your bank balance depends on how much you earn.
AJ Bell estimates that someone earning £15,000 today will pay an extra £259 in tax over the next three years because of the frozen thresholds. This increases to £683 for someone earning £45,000, and £1,293 for the highest earners.
“For workers across the spectrum, the impact is sharp,” says Rachael Griffin, a tax and financial planning expert at Quilter. “Pay growth that would once have felt like genuine financial progress now pushes people into higher rates of tax far earlier than expected.”
If the personal allowance had increased with inflation each year, it would now be around £15,550, and it would have hit £17,470 by 2030. Instead, it is stuck at £12,570.
Similarly, the threshold for paying higher-rate income tax would be around £62,189 today without the freeze, growing to £70,370 in 2030. But it will remain at £50,270.
It’s not just about higher tax bands
Workers hitting the frozen higher-rate income-tax threshold face a raft of other costs, too. Their personal savings allowance shrinks, from £1,000 to £500, and it disappears altogether for additional-rate taxpayers. They also start paying higher rates of dividend and capital gains tax.
All that adds up to people paying a lot more tax across the board.
For families with children, crossing £50,000 means that the high-income child benefit charge kicks in, wiping out part or all of their benefit. With that frozen too, ordinary pay now pushes far more parents over that line.
If you are approaching the next income tax bracket, there are steps you can take to minimise the hit. Consider using salary sacrifice schemes, or increasing your pension contributions to reduce your taxable income.
Using fiscal drag to raise revenues means we have a tax system that takes more money from you without the rate you pay appearing to change.
“The cost is transparency,” says Griffin. “Households will feel the squeeze long before they understand where it came from.”
With thresholds now locked until 2031, that squeeze is only going to get stronger.
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