Fiscal Drag: Why you are getting paid more, but have less money to spend

QUESTION: Over the past few years, I have had some incremental pay rises, but I still don’t have any additional money to spend each month. Is this due to the cost of living increasing as there haven’t been any real tax increases?

ANSWER: In recent years, millions of UK taxpayers have found themselves paying more in taxes without a single official tax rate increase. This phenomenon, known as fiscal drag, has been exacerbated by the government’s decision to freeze key tax thresholds, meaning more people are being pulled into higher tax brackets due to rising wages and inflation.

With the tax burden at a historic high, the effects of fiscal drag are becoming more apparent, and the financial pressure on households is intensifying.

Fiscal drag occurs when tax thresholds remain static while wages increase, often due to inflation.

As salaries rise, more individuals find themselves in higher income tax bands, paying a greater proportion of their earnings to the government.

This can result in reduced disposable income, lower spending power, and financial strain for those already struggling with the cost-of-living crisis.

Since 2022, the UK government has frozen personal allowance and higher-rate tax thresholds, meaning that more middle-income earners are being pushed into paying 40% income tax.

The tax-free personal allowance remains at £12,570, while the higher-rate threshold is still set at £50,270.

Meanwhile, inflation and wage growth have caused salaries to rise, increasing the number of people affected by fiscal drag.

The impact of fiscal drag is widespread, affecting a broad spectrum of workers.

Low-income earners who previously paid little to no tax are now being drawn into the basic rate tax band, while middle earners are being pushed into the higher-rate bracket.

Higher earners are also finding themselves paying more tax than before as the additional rate threshold was lowered from £150,000 to £125,140 in April 2023.

Additionally, pensioners and those receiving state benefits tied to income thresholds may also be negatively impacted.

Many workers receiving pay increases in line with inflation are seeing little actual improvement in their financial situation because a larger portion of their income is taxed at a higher rate.

Fiscal drag has several economic consequences. Firstly, it reduces household disposable income, which in turn affects consumer spending, a crucial driver of economic growth.

With less money to spend, businesses may see lower sales and reduced profitability, leading to slower economic expansion.

Furthermore, the increased tax burden could discourage productivity and aspiration.

Employees who see their earnings eroded by tax hikes may be less incentivised to work additional hours or seek promotions, impacting workforce morale and overall economic output.

Some economists argue that adjusting tax bands in line with inflation would prevent the stealth tax increase caused by fiscal drag. Others suggest that targeted tax cuts could help alleviate the financial strain on households.

For now, UK taxpayers should be aware of how fiscal drag may affect them and consider financial planning strategies to mitigate its impact.

Feargal McCormack (feargal.mccormack@aabgroup.com) is managing partner at AAB Group Accountants Limited (www.aabgroup.com). The advice in this column is specific to the facts surrounding the question posed. Neither the Irish News nor the contributors accept any liability for any direct or indirect loss arising from any reliance placed on replies.