One in five taxpayers will be paying higher-rate income tax by 2027, according to a leading thinktank.
The Institute for Fiscal Studies (IFS) says that many teachers, nurses and electricians are among the one in five taxpayers who will be paying the 40% tax rate (levied on those with an income between £50,271 to £150,000) because of a six-year freeze on thresholds implemented by Chancellor Jeremy Hunt and ‘fiscal drag’.
It means there will be 2.1 million more higher rate taxpayers and 350,000 additional-rate taxpayers in five years' time, according to the Office for Budget Responsibility (OBR).
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In total 7.8 million people are projected to be paying income tax at 40% or above by 2027-28.
This represents a “seismic shift” and around a quadrupling of the share of adults paying higher rates since the early 1990s, said the IFS.
In 1991-92, 3.5% of UK adults (1.6 million) paid the 40% higher rate of income tax. By 2022–23, 11% (6.1 million) were paying higher rates, the report added.
It shows that over recent decades, higher rates of income tax have gone from being reserved only for the richest to something that a far more substantial proportion of the population can expect to encounter.
The report predicted: “By 2027–28, more than one in eight nurses, one in six machinists and fitters, one in five electricians and one in four teachers are set to be higher-rate taxpayers.
“Among police officers, architects and surveyors, and legal professionals, we also see significant increases in the share paying higher-rate tax over time, with almost half of the latter two groups expected to be paying higher-rate tax in 2027-28.”
What is fiscal drag?
Wage growth is currently 6.7%, according to the Office for National Statistics. Due to the freeze on tax bands, many workers will find themselves ‘dragged’ into a higher tax band, even though they have not had a proper pay rise that leaves them better off in real terms. This is known as ‘fiscal drag’.
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.
Rachael Griffin, tax and financial planning expert at Quilter, says “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.”
“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.”
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.”
You can also scrutinise expenses whatever your employment status. “If you’re self-employed, ensure you’re claiming for all those allowed by HMRC as a result of your work,” say Justin Modray of Candid Financial Advice.
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