What is fiscal drag?

Jeremy Hunt had two options available to him to stabilise the UK’s finances when he put together his Autumn Budget. With a £50bn+ plus black hole to fill, the chancellor had to either cut spending or hike taxes. He did both, and he’s relying on an economic principle called “fiscal drag” to help him balance the books. 

Where does the government get its money from?  

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. 

What is fiscal drag?  

Fiscal drag is all about how tax thresholds interact with inflation. It’s a great way of essentially raising taxes without telling anyone you’re raising taxes.  

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 2022-2023 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.  Partly due to inflation and partly due to economic growth, wages in the UK for full-time employees have risen from £406 a week to £533 a week on a median basis over the past decade.  

And wage growth has accelerated this year. Even though wages are not keeping pace with inflation, they are still growing at one of the fastest rates in recent history. The annual rate of pay growth, excluding bonuses, in the private sector rose to 6.6% in the three months to September.  

However, the government is keeping the bands at which you pay different rates of tax static until 2028 at the earliest.  

How will fiscal drag impact your finances?  

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). While some workers who’ve never paid taxes may have to start paying.  

Take the current £12,570 nil rate income tax personal allowance. If this were to increase in line with wages, it should rise to £13,400 in April next year. If it grows in line with inflation, the band should grow to £13,965.  

But if it’s held steady, someone earning £12,570 who is paying no income tax currently, will have to pay income tax if they get a pay rise in line with inflation next year.  

So, while their wages might increase with inflation before tax, after tax they’ll see a below-inflation rise.  

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.