The £40bn stealth tax set to hit millions of workers

One of the key weapons in the government’s armoury for raising revenue without the bad press that goes with putting up headline taxes is a phenomenon known as fiscal drag.

This is basically what’s going on when tax thresholds – the levels of income at which people start to pay a higher rate of tax on their “marginal” earnings above the threshold – don’t keep up with rises in average incomes, instead of being indexed to increase in line with them. The result is that over time, as earnings rise, more people creep into a higher tax bracket.

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Most significantly for the Treasury coffers, those who were earning less than the personal allowance (currently £12,570) and didn’t pay any tax, may find their income starts to exceed their allowance as their salaries increase, so they start to pay basic-rate tax on that marginal chunk of earnings. Those earning around the higher-rate threshold (£50,270) may similarly be tipped into the higher tax bracket.

Fiscal drag has a greater impact when price inflation is fuelling wage inflation at the same time as tax thresholds have been frozen altogether. As a consequence, people find their wages going up (to reflect rising prices) yet are simultaneously having tax siphoned off at a higher rate because their income has been pushed into the next tax bracket.

That’s exactly what is happening in the UK right now.

3.7 million more taxpayers

Rapid increases in living costs over the past three years have meant that average wages are now rising at around 6% a year, according to Incomes Data Research. Meanwhile, the Conservatives have not altered tax thresholds since the 2022-23 tax year, and have pledged to keep them at current levels until 2028. Labour is taking the same stand.

Higher and more persistent than expected inflation has resulted in higher levels of fiscal drag, impacting greater numbers of people and bringing in more tax revenue than previously estimated.

According to the March 2024 report from the Office for Budget Responsibility (OBR), the freeze of personal allowance and higher-rate thresholds alone will raise over £33.5 billion for the government in 2028-29 – more than £8 billion higher than the OBR forecast in last year’s report. 

When you include other measures that contribute to the fiscal drag trend, such as the national insurance (NI) threshold freeze and the lowering of the additional tax threshold, that £33.5 billion rises to £43.6 billion by 2028-29.

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These big numbers make clear that fiscal drag is not to be dismissed lightly; but the OBR report data also provides a stark demonstration of the financial reality over the coming four years for millions of people in the UK as a consequence of threshold freezes.

By 2028, it says: “There are expected to be around 3.7 million more taxpayers overall, 2.7 million more higher-rate taxpayers, and 600,000 more additional-rate taxpayers than if all allowances and thresholds had been indexed to inflation and the additional rate kept at £150,000.”

To put those increases into some context, the total number of taxpayers will be up by around 10% and the number of higher-rate taxpayers will be almost 60% higher, specifically as a result of fiscal drag.

How threshold freezes are hitting households

The monetary impact on households is considerable too. Those on low incomes who are dragged above the personal allowance in 2022-23 will potentially be paying 20% basic-rate tax on almost £3,500, while taxpayers pushed into the 40% higher-rate bracket will be liable to 40% tax on more than £14,000 by 2028.

Nonetheless, because there are no changes to headline tax rates, and taxpayers often don’t really register the fact that their tax burden has gone up, fiscal drag is an attractive option for governments. In effect, it’s a prime example of a stealth tax.

Indeed, as Robert Salter, director of accountancy firm Blick Rothenberg, observes, a government may actually be able to claim that it is cutting some taxes, while tax revenues are increasing from the effect of fiscal drag. 

“One could argue that the last Conservative government did this, when it talked about reducing the employee (and self-employed) rates of NI, while still getting much greater sums of money overall from the simple impact of fiscal drag on incomes generally,” he points out. 

Thus, the gross figure of £43.6 billion by 2028-29 mentioned above is somewhat offset by around £2.5 billion of much-trumpeted “tax giveaways” in the shape of reductions to NI announced by Chancellor Jeremy Hunt in the 2023 Autumn Statement, to produce net receipts of £41.1 billion over the period.

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Salter makes the additional point that fiscal drag not only operates as a stealth tax, but is also fundamentally unfair. “It disproportionally impacts those on lower or medium income levels, rather than the highest earners,” he says.

Moreover, he explains: “The reality is that it also means more and more taxpayers get exposed to the various tax anomalies within the UK tax system – that is, the effective tax rates which are much higher than the official highest tax rate of 45% (or 47% if you include the NI surcharge).”

One example is the Higher Income Child Benefit charge. This is a benefit paid to families where one earning partner makes between £60,000 and £80,000; but the amount received starts to taper once that partner’s income rises above the £80,000 threshold, acting in effect like a tax hike on the household finances.

Another is the personal allowance taper, which kicks in to reduce the personal allowance by £1 for every £2 of extra earnings on income between £100,000 and £125,000. “It means that the effective rate of income tax is 60% for people in this pay bracket,” observes Salter.

Thirty hours a week of free government childcare and the tax-free childcare scheme are also available to families where both parents earn less than £100,000. But as Salter explains: “This limit is an absolute cliff edge, so if one parent suddenly received a wage rise that took them over the £100,000 limit, all childcare becomes taxable.”