Too embarrassed to ask: what is fiscal drag?

How can politicians raise more tax revenue, without damaging their political popularity too badly? One way is by using “fiscal drag”. Here's what that means.

When a government wants to raise money to spend on public services, it has two main options. It can borrow the money, but this has to be repaid at some point. The only reason investors are willing to lend money to governments is because they know that the debt is backed by future tax revenues. Which brings us to the other method governments have of raising money – taxation.

By raising money through taxes such as income tax, or stamp duty, or VAT, governments pay for public services, the welfare state, and interest payments on the national debt. There’s just one problem: people generally like the idea of having well-funded public services. They even like the idea of higher taxes – as long as other people are paying them. But they themselves are rarely keen to pay more tax.

So how can politicians raise more tax revenue, without damaging their political popularity too badly? This is where “fiscal drag” is a handy tool.

In a progressive tax system like Britain’s, most taxes have different bands at which you pay different rates of tax. The more money you make, the more of it you pay in tax. For example, in the 2020-2021 tax year, people living in England, Northern Ireland and Wales who earn less than £50,000 a year, pay a maximum income tax rate of 20%. After that, it goes up to 40%, and eventually to 45%.

Now, in a typical year, most people get some sort of increase in their wages, linked to the cost of living. This is not a pay rise as such – it just means that your wages are keeping up with inflation. However, there is no guarantee that tax bands will increase every year by inflation too. Governments sometimes hold them static.

As a result, some workers who previously only paid the basic rate in tax will end up paying the higher rate – even though their wages haven’t risen in “real” terms (that is, after inflation). This is fiscal drag. Put simply, it’s what happens when more and more people end up being caught in the tax net, simply because of inflation, rather than because they are genuinely wealthier.

To find out more about how fiscal drag and other stealthy tax increases affect your finances, subscribe to MoneyWeek magazine.

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