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What is fiscal drag?
The Oxford dictionary defines it as:
‘The deflationary effects of a progressive taxation system on a country’s economy. As wages rise, a higher proportion of income is paid in tax’
The recent comments made by the Chancellor in the Autumn Statement, froze most Income Tax allowance and rates at current levels until 2028.
This means that wage earners who receive pay increases until April 2028, to try and keep spending power intact, will pay income tax on any increase. In certain circumstances, they may also see their taxable income boosted into the 40%, or 45%, Income Tax bands.
If wage increases continue to lag behind inflation, then wage earners will suffer a double hit to their spending power in coming years.
You may have encountered this phrase, fiscal drag, in recent weeks, particularly if following the Autumn Statement announcements last week.
A large part of Chancellor Hunt’s announcements confirmed that rates and allowances for Income Tax are to be frozen at current levels until April 2028.
Your immediate response to this news may have been one of ‘underwhelm’. No changes so no worse-off.
But in many cases, this would be an incorrect assumption.
As we are frequently reminded, with inflation currently running at over 11%, you would need to secure a pay increase of 11% to maintain the purchasing power of your take-home pay.
Unfortunately, if you are already a taxpayer, you would need a pay increase in excess of 11% to maintain your spending power.
For example, freezing your annual tax-free personal at the current £12,570 means any additional income you earn will by taxed (on the assumption that you are already paying tax) and it will be payable at your top rate.
In certain circumstances, this may mean paying tax at higher rates for the first time.
This double hit on your earnings, from inflation and tax on pay increases, will likely result in falling disposable income in the coming years.
May be time to dust off ideas for additional income streams?