The increasing pull of fiscal drag

This month’s Autumn Statement has led to an onslaught of headlines featuring the phrase ‘fiscal drag’.

Sometimes referred to as a ‘stealth tax’ the term doesn’t normally move beyond the Westminster bubble or the financial pages so why is it currently causing so much of a stir?

To understand why commentators are getting so animated about it, we first need to look at what the term means.

What is fiscal drag?

Fiscal drag is a term economists use to explain what happens when tax thresholds do not increase in line with the rising cost of living.

Typically, each year employees can expect to see their wages increase to some extent to help them keep up with the cost of living. This is not a pay rise, rather it is an attempt to ensure employees’ wages are keeping up with inflation.

However, if tax thresholds are not also increased you end up with a situation where more of the lowest earners begin to pay tax for the first time and other workers move into higher tax bands.

For example, currently the nil rate income tax personal allowance stands at £12,570. If this were to grow in line with wages, it should increase to £13,400 next April. If it were to grow in line with inflation it would increase to £13,965.

Without an increase to the tax threshold, someone currently earning £12,570 will be liable to pay tax for the first time if they receive a pay rise in line with inflation in 2023.

This means that although the individual has received a wage increase in line with inflation, after tax they will see a below-inflation rise.

Put simply, fiscal drag is when people pay tax for the first time – when they pay more tax – or when people are dragged into higher tax brackets – not because they are wealthier but because they are attempting to counter effects of inflation.

What happened in the Autumn Statement?

In the Autumn Statement, the Chancellor of the Exchequer, Jeremy Hunt, revealed that the nil income tax personal allowance, which stands at £12,570, would be frozen until 2028.

The Basic Rate income tax band, which goes from £12,571 to £50,270 and at which individuals are charged 20 per cent, will also be frozen until 2028.

In addition, the Chancellor announced that the threshold for when the highest earners start paying the top rate of tax – 45 per cent – will fall from £150,000 to £125,140 from April 2023.

These announcements apply to England, Wales and Northern Ireland. Scotland sets its own bands and rates.

What will the impact be?

The Government’s economic plans are independently assessed by The Office of Budget Responsibility.

It estimates that freezing thresholds until 2028 will create an additional 3.2 million new taxpayers and will mean 2.6 million more people pay higher rate tax.