Fiscal drag: An explainer

Defining fiscal drag

Fiscal drag occurs when tax thresholds and allowances do not keep up with inflation or wage growth, resulting in more of a taxpayers’ income being taxable.

This can also mean that more income is taxed at a higher rate – or more taxpayers are ‘dragged’ into paying tax at a higher rate.

The Office for Budget Responsibility (OBR) defined fiscal drag in a 2014 information release (PDF) as “the process by which the average tax rises if allowances and thresholds are indexed to prices rather than earnings, resulting in more taxpayers’ income falling into higher tax bands.”

Fiscal drag is not an uncommon economic phenomenon, and its magnitude depends on three elements: the setting of thresholds and allowances, growth in prices (inflation), and growth in earnings.

Setting thresholds and allowances: The Government’s indexation policy

The process of increasing thresholds proportionally in line with the growth of an index is called ‘indexation’.

The UK Government has a policy of increasing certain thresholds and allowances each year in line with inflation (a process known as ‘uprating’).

Uprating applies to a variety of direct and indirect taxes. Other thresholds are set at a fixed value and there is no default uprating policy.

Uprating policies, however, are not always observed. When thresholds and allowances are ‘frozen’ (that is, fixed at the same value) there is an overall increase in tax paid to the Treasury without an actual increase in tax rates.

The Treasury produces a table of the “indexation assumptions” on which public finance forecasts are based. The latest one is in Annex A of the 2022 Autumn Statement Policy Costings document (PDF).  

Spring Budget 2021: Freezing Income Tax thresholds

Recent policy measures have meant fiscal drag is having an increased impact on the public finances. In the 2021 Spring Budget, as Chancellor, Rishi Sunak announced the income tax Personal Allowance and Higher Rate Threshold (HRT) would be uprated in line with inflation for 2021/22 (following the default policy), and then remain frozen until 2026.

At the time, the OBR estimated in its Economic and Fiscal Outlook (PDF) that the measure was going to raise £8 billion per year by 2025/26 (Table 3.1, p93).

Spring Statement 2022: Freezing National Insurance thresholds

In the 2022 Spring Statement, then Chancellor Rishi Sunak announced the following would be aligned with the income tax personal allowance:

• the Primary Threshold (PT) for Class 1 National Insurance contributions (NICs)
• Lower Profits Limit (LPL) for Class 4 NICs

Both were raised from £9,880 to £12,570 per year.

income tax thresholds are set to remain at the same level until April 2026. As a result, it is expected that NICs thresholds will stay at that level as well.

 In the Spring Statement, Rishi Sunak said  raising the NICs Primary Threshold and LPL would deliver an average saving of £330 in the year from July 2022. OBR analysis in the March 2022 Economic and Fiscal Outlook said the amount saved by taxpayers would diminish until 2025/26 due to NICs thresholds being frozen.

The Institute for Fiscal Studies has analysed the impact of freezing the PT and LPL, concluding in August 2022 that the average reduction in NICs for typical employees would decrease to £48 in 2025/26.

Autumn Statement 2022: Extending the freeze

In the 2022 Autumn Statement, Chancellor Jeremy Hunt announced the freeze of the income tax Personal Allowance and higher rate threshold, as well as NICs Class 1 PT and Class 4 LPL would be extended to April 2028 instead of 2026.

The OBR estimated in its November 2022 Economic and Fiscal Outlook (PDF) that the income tax parameter freeze alone will raise £26 billion to the Exchequer by 2027/28 (pp33-34).

Analysis and commentary

In the October 2021 Economic and Fiscal Outlook (PDF), the OBR estimated the freeze to raise £12.9 billion per year by 2025/26 (para 3.25, p102), and to £18 billion in the March 2022 Economic and Fiscal Outlook (PDF – table A.5., p205).

When the freeze was announced to be extended by further two years to 2027/28, the OBR said in its November 2022 Economic and Fiscal Outlook (PDF) that the freeze of the income tax thresholds alone would raise £26 billion per year by 2027/28.  

Since freezing thresholds raises overall tax revenue without taxes actually increasing, some critics have branded the measure as a “stealth tax”, as reported by the Observer in its analysis of the 2022 Autumn Statement. Think tanks such as the Resolution Foundation and the IFS have warned against relying on freezing thresholds for a long time as a way to raise revenue. However, other commentators have argued there is a case for this type of tax increase. An editorial in the Financial Times in March 2022 said that they do not oppose ‘stealth taxes’ in principle, arguing that the thresholds freeze in a high-inflation environment would help raise revenue to cover the cost of Covid-19 schemes. However, they also added that, in the current climate, the reduction in the real value of people’s incomes would be felt.