Almost 1.5 million more people will be dragged into higher tax bands by 2027

Almost 1.5 million more people will be dragged into higher tax bands by 2027-28, according to an FOI submitted to HMRC.

The tax authority forecasts that 1,130,000 more people will pay higher-rate tax, while 301,000 more people will become additional-rate taxpayers.

This is a consequence of fiscal drag and frozen tax allowances: the higher-rate tax band (levied at 40% on those with an income between £50,271 to £150,000) is frozen until 2027-28, as announced by Jeremy Hunt in last year’s Autumn Statement. 

Meanwhile, wage inflation is pushing workers’ salaries higher. It means a larger portion of people’s incomes will be taxed, and some will fall into higher tax brackets.

Rachael Griffin, tax and financial planning expert at Quilter, the wealth manager that submitted the FOI, said: “These figures illustrate HMRC is well aware of the power of fiscal drag and exactly how many people they expect to be dragged into paying more tax due to the frozen thresholds.

“Freezing income tax bands is a form of stealth tax as you’ll end up paying considerably more tax during the time bands are frozen, which will be on top of higher energy and food costs.”

The Treasury is already benefiting from the frozen tax allowances. Receipts from income tax and National Insurance payments for April to December 2022 reached £281.1 billion – an increase of £34.3 billion compared to the same period a year earlier.

What is fiscal drag?

Fiscal drag happens when the income level at which taxes start to be collected and the amount of income that can be earned tax-free fail to increase at the same rate as inflation or income growth.

Usually, tax bands increase with inflation. However, the chancellor froze the thresholds in his Autumn Statement. The personal tax allowance - the amount of income you can earn before you start paying income tax on it - will not increase in April; instead, it will remain at its 2022-23 level of £12,570. Hunt also cut the 45% additional-rate tax band from £150,000 to £125,140, which will come into effect in April.

These tax freezes and tax cuts coupled with big wage increases are pushing more and more people into higher tax bands. Last week, official figures revealed that wages have grown at their fastest rate since records began in 2001, with average pay rising by 6.4% between September and November compared with the same period in 2021.

Calculations by Quilter show that if wage growth averages 5% per year for the next four years but income tax thresholds remain frozen, then someone earning £50,000 today will be £2,643 worse off in the 2027-28 tax year, and in total be £6,463 poorer over the four-year period.

Griffin explains that high inflation means that despite someone receiving a pay rise they may not feel wealthier as their buying power remains the same - however, their salaries will be taxed much more.

Tax receipts soar

The government is already enjoying a bumper set of tax receipts, due partly to its policy of freezing multiple tax allowances.

As well as an increase in how much HMRC collected via income tax and National Insurance, there was also a boost in inheritance tax receipts from April to December last year. HMRC received £5.3 billion, which is £0.7 billion higher than in the same period a year earlier.

The inheritance tax (IHT) thresholds have been frozen until 2027-28.

“The latest bumper tax haul shows that the deep freeze to tax thresholds has already started to bite,” comments Myron Jobson, senior personal finance analyst at the investment platform interactive investor.

“It is a sneaky way for the government to replenish the public kitty following big spending on Covid and cost-of-living support measures. But the heightened tax burden comes at a time when many can least afford it.”

How can I avoid fiscal drag?

Unfortunately, fiscal drag affects us all – even if you don’t change your tax band. That’s because as your pay rises with inflation, more and more of your pay packet is taxed and your overall tax burden increases.

However, prudent financial planning can help lessen the impact. Using an ISA can shelter your savings and investments from the taxman and ensure you don’t pay unnecessary tax. Using a pension can turbo-charge a retirement nest egg thanks to the power of tax relief. We also have plenty of tips on how to reduce a potential inheritance tax bill. 

You may be able to take advantage of tax breaks too, like the marriage allowance. This is where one person in the couple has an income below the personal allowance (£12,570), and by transferring part of the allowance, the couple can save up to £252 in a tax year.

If a pay rise means your salary has just tipped into a higher tax band, you could use salary sacrifice to lower it. 

Griffin explains: “One option might be to make additional pension contributions via salary sacrifice essentially lowering the taxable portion of your salary and potentially reducing it under the higher rate of tax threshold.”

As well as pension contributions, some employers offer benefits ranging from gym memberships to the cycle-to-work scheme, which can be paid for via salary sacrifice.