Fiscal drag could cost millions of earners thousands – what is it, and how can I protect my money?

Income tax thresholds have been frozen since the 2022 tax year, and will stay the same until the 2027/28 tax year.

In the 2021 Budget, then-chancellor Rishi Sunak announced income tax brackets would not be adjusted yearly, as had been the norm, for four years. Jeremy Hunt subsequently extended the freeze for a further two years.

It means millions of taxpayers in the UK could see their tax bills climb in the coming years as their pay increases.

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The damage is already being done. New research from the TaxPayers’ Alliance shows that every percentile of taxpayers apart from the top 1% of earners are paying a higher proportion of income tax today than in 2021 thanks to fiscal drag.

The group most squeezed by fiscal drag are the top 11% to 25% of earners who will now pay 17% of total income tax receipts, up 1.9 percentage points from 15.1% since 2021/22, the report shows. The top 2% to 10% of earners now pay 32% of total income tax receipts, up 0.9 percentage points from 31.1%.

The only group of earners who are paying a lower proportion of income tax is the top 1% who will pay 26.6% of the total income tax collected, down from 30.7% in 2021/22.

There are almost 2.9 million more people paying the basic rate of income tax in the 2025/26 tax year than in 2021/22, just before tax thresholds were frozen, the analysis found.

There are more higher rate tax payers too – the data shows that over 2.6 million more people have been dragged into the 40% tax bracket. The number of additional rate taxpayers (45%) also increased by 696,000 since the 2021/22 tax year.

Meanwhile, separate analysis by Quilter in April found that, by 2027-28, 17.9 million people could pay income tax for the first time ever as wage increases and inflation outpace the £12,570 tax-free personal allowance.

This includes 8.2 million who will be aged over 60, many of whom will be paying tax on their pensions for the first time.

With fiscal drag potentially meaning that millions in the UK pay more tax over the next few years, we explain what it is, and how you can protect yourself from it.

What is fiscal drag?

Fiscal drag is simply the term used to describe what happens when a government does not adjust their income tax thresholds according to inflation and wage growth data.

This means that a higher number of taxpayers are dragged into paying tax for the first time, or at a higher rate, despite the purchasing power of their money not increasing at the same rate.

For example, in Autumn 2022 (when tax bands were frozen), the tax-free personal allowance was £12,570.

According to the Bank of England’s inflation calculator, £12,570 in 2022 is now worth around £14,056 in March 2025 when adjusting for inflation.

Normally, tax bands are adjusted for inflation, but, because they have been frozen, people today who earn the equivalent of £12,570 in 2022 (which is £14,056 in 2025) are now paying tax on the £1,486 difference that has occurred thanks to inflation.

Therefore, people are being dragged into paying tax despite not earning more money in real terms. Given the tax rate doesn’t rise, but the amount of tax raised increases, it is sometimes called a ‘stealth tax’.

Why did the government freeze tax thresholds?

One of the government’s driving reasons for implementing the freeze in 2022 was to stabilise the UK’s finances following a big increase in spending during the Covid-19 pandemic and the instability caused by Liz Truss’ ‘mini-budget’.

Freezing tax bands, in their eyes, was therefore a way to help balance the books and get some more cash back into the public coffers at a time when it was desperately needed.

Politically, raising taxes can be a very contentious issue – few people like seeing more of their hard-earned money taken out of their payslip.

Frozen tax thresholds can be preferred by politicians as, on the surface, it doesn’t look like taxes are being raised.

However, this is also the reason why many individuals and groups oppose the practice and call it a ‘stealth tax’.

There is a worry that fiscal drag can “easily go under the radar and cause a bit of a shock when you see your payslip”, according to Camilla Esmund, senior manager at interactive investor.

“We’re seeing wage growth in the UK, which is obviously fantastic, but the adverse effect of this is that the number of people paying the higher or additional rate of income tax has increased,” she concluded.

Fiscal drag impacts more than just how much income tax you pay, according to Sarah Coles, head of personal finance at Hargreaves Lansdown.

Coles says the phenomenon could lead to “potentially higher rates on everything from dividend tax to capital gains tax, and a shrinking personal savings allowance.”

How can you protect your money from fiscal drag?

While there aren’t many direct ways of avoiding fiscal drag apart from refusing to let your wages increase, there are some clever ways that you can mitigate its impact on your money.

First of all, it is important to get an idea of what your pay will look like for the year ahead so that you can plan accordingly.

“It’s always going to be difficult to predict whether you’re going to get a pay rise, and if so, how big it will be,” says Coles.

“However, it’s worth making an estimate and checking whether this will take you over a tax threshold into paying a higher rate of tax in the current tax year.”

Once you have established this, you can start to consider whether it is worth it for you to implement measures so that your income stays below the tax bracket you would otherwise enter.

This can be in the form of increased pension contributions or looking into salary sacrifice. Those who are set to breach tax thresholds may also want to utilise the £20,000 tax wrapper that comes with a cash ISA or stocks and shares ISA.

Make the most of your ISA allowance

Using the ISA tax wrapper can “help stop your savings and investment income push you over a threshold,” says Coles. This is because any growth that your money achieves in these accounts will not be taxed.

Esmund at interactive investor echoes this view, saying: “ISAs and SIPPs are great tools. To keep more of your money, a good strategy is to make the most of tax wrappers and to keep your portfolio costs low (keep an eye on fees).”

“Though few of us will be able to max out the £20,000 allowance each year, prioritise using the most of this allowance before the allowance refreshes – even if you’ve not decided how to invest it, it’s worth making the contributions,” she continued.

Put more into your pension

A way to reduce your taxable income is by putting more of your salary away into your pension – this method “should not be underestimated”, according to Esmund.

This is because “unlike ISAs, you can roll over any unused allowance from the past three years and claim tax relief”. She added: “In fact, if you’re nervous about your tax bill – one option could be paying a bit more into your pension.”

Esmund notes that while this will leave you with less money in your pay packet at the end of each month, you will get upfront tax relief on your contributions – and you’ll still be able to enjoy the cash when you retire.

If you do this, “you’ll get an immediate 25 per cent boost in the form of a government top up and can claim back extra through self-assessment if you earn enough to pay 40 per cent or 45 per cent tax,” she said.

Consider salary sacrifice

Salary sacrifice offers another way for you to reduce your salary and therefore avoid the negative effects of fiscal drag.

Coles at Hargreaves Lansdown explains that “in some cases, the government will let you give up a portion of your salary, and spend it on certain things free of tax (and in some cases National Insurance).”

Salary sacrifice could be used to put more in your pension, get childcare vouchers, buy a bike through the bike-to-work schemes, and could be spent on other technology schemes.

“Where employers offer to put their NI savings into the scheme, the hike in employers’ NI will make this an even more attractive option. It won’t boost your take-home pay, but will cut your tax bill, and make your money go further, so it’s worth checking with your employer whether they offer this,” she added.

Plan your income

Another way to avoid the worst of fiscal drag is to carefully plan when your income enters your account.

Coles explains: “If there’s a time when you expect to be paying a lower rate of tax, consider whether you can take income then rather than now.”

For example, you could opt for a fixed term savings account that pays interest annually, instead of an easy access option which pays more frequently. You could then have the fixed savings interest pay out once you’re in a lower tax bracket.

“This often makes sense just before retirement,” according to Coles. “If this money is currently sitting in accounts paying interest in the current tax year, then from a tax perspective, the sooner you move them, the better.”