“Invisible Pay Cut”: Understanding the Impact of Fiscal Drag on Your Income

The term “fiscal drag” might not be something you come across daily, but it’s something that could be silently impacting your finances. As salaries increase to match the cost of living, many individuals find themselves paying more taxes, not because they’ve gotten significant raises or because tax rates have gone up, but because the tax brackets themselves haven’t adjusted alongside wage or inflation increases. An article in The Times breaks down what this all means for the average worker.

What Exactly is Fiscal Drag?

Fiscal drag is a complex term for a simple concept: it happens when tax thresholds don’t rise in line with wage or inflation increases. Think of it as an “invisible pay cut.” Your salary might go up in nominal terms, but because the tax brackets stay the same, more of your income could be taxed at a higher rate. You’re making more, but the extra taxation might mean you’re not taking home as much as you expected.

HM Revenue and Customs (HMRC) figures point out that 4.2 million more workers are now paying a 20% income tax rate compared to three years ago. Even more startling, an additional 1.6 million people are now in the 40% tax bracket — all because tax thresholds were frozen back in 2021 and are expected to remain so for several years.

The Institute for Fiscal Studies anticipates that, due to this freeze, one in five workers could be paying the 40% tax rate by 2027. All this without a real increase in earnings!

Why Should You Care?

Why does fiscal drag matter to you? Because it can significantly impact your take-home pay.

For instance, if your earnings are £50,000, don’t assume you’re safe from the higher tax bracket. With a projected 5% wage growth annually, you could be earning £60,775 in four years, pushing a substantial portion of your income into the higher tax rate — costing you more than you might expect.

According to calculations from the investment platform AJ Bell, someone with a £50,000 salary could end up paying an extra £9,000 in taxes over six years of the threshold freeze, compared with if the threshold had increased with inflation.

Even if you’re earning less, say £42,000, with the same 5% wage growth, you’d find yourself earning £51,051 by 2027/28, making you subject to the higher tax rate as well.

Thankfully, there are strategies to mitigate the impact of fiscal drag on your finances.

Pension Contributions

Increasing your pension contributions can reduce your taxable income, potentially keeping you below the higher tax threshold. For example, if you’re projected to move into a higher tax bracket, contributing that excess into your pension instead could not only save on taxes but also boost your retirement savings. This strategy does mean you’ll have less take-home pay now, but it could lead to long-term financial benefits.

Utilising ISAs

Individual Savings Accounts (ISAs) are another excellent tool. You can use your £20,000 ISA allowance for savings or investments, the returns on which are tax-free and don’t need to be reported on your tax returns. Couples can combine their allowances for even greater tax-efficient saving.

Other Options

For the self-employed, ensuring you’re deducting all allowable expenses can reduce your taxable income. Additionally, couples might benefit from the marriage allowance, and charitable donations can also reduce your tax bill.

The Bigger Picture

Fiscal drag doesn’t just affect income tax. It also impacts inheritance tax (IHT) and capital gains tax (CGT). With the IHT threshold frozen until 2027-28, rising property values might mean more people have to pay more IHT. Meanwhile, CGT allowances are decreasing, meaning you could pay more tax on the sale of assets like a second property or shares.

Preparing for the Future

As fiscal conditions change, it’s crucial to stay informed and plan accordingly. While fiscal drag may not be widely discussed, its impact is far-reaching, affecting millions of workers. By understanding what it is and how it works, you can take proactive steps to protect your finances both now and in the future.