Fiscal drag: An explainer

What is fiscal drag?

Freezing tax thresholds increases people’s taxable income without tax rates actually increasing. This results in additional revenue to the government. This phenomenon is called ‘fiscal drag’, as more taxpayers are ‘dragged’ into paying tax, or into paying tax at a higher rate.

Although fiscal drag is not uncommon, its size depends on three elements: the setting of thresholds and allowances (also known as just ‘thresholds’), growth in prices (inflation), and growth in earnings. How thresholds are set is an important determinant of the magnitude of fiscal drag, especially if inflation is high.

How does the government set tax thresholds?

The process of increasing thresholds proportionally in line with the growth of an index (such as inflation) is sometimes called ‘indexation’.

The government has a policy of increasing certain thresholds each year in line with inflation (PDF). This process is known as ‘uprating’. Uprating policies are not always observed. When thresholds and allowances are ‘frozen’, there is an overall increase in tax paid to the Treasury without an actual increase in tax rates.

In the UK, a number of tax thresholds (particularly income tax ones) have been frozen since April 2022, and are currently expected to remain so until April 2028.

Fiscal drag: A sensible ‘stealth tax’?

The impact of the tax thresholds freezes has been analysed by the OBR in multiple economic and fiscal outlooks since the first announcement in the 2021 Spring Budget. In terms of income tax, the latest estimate is that the freeze of income tax thresholds will raise over £33.5 billion a year in 2028/29 (PDF).

Since freezing thresholds raises overall tax revenue without tax rates actually increasing, the policy has also been branded as a “stealth tax”, as reported by the Observer in its analysis of the 2022 Autumn Statement. Think tanks such as the Resolution Foundation (PDF) and the Institute for Fiscal Studies (PDF) 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 measure. An editorial in the Financial Times in March 2022 said that they did 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 a high-inflation environment, the reduction in the real value of people’s incomes would be felt. The government said that the value of the personal allowance (the amount of money which is income tax-free) is the highest in the G20, and that the government had almost doubled it since 2010.

What policy decisions on tax thresholds have been made since 2021?

Spring Budget 2021

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 uprating policy), and then remain frozen from April 2022 until 2026.

At the time, the Office for Budget Responsibility (OBR) estimated in its Economic and Fiscal Outlook that the measure was going to raise £8 billion per year by 2025/26.

Spring Statement 2022

In the 2022 Spring Statement, then Chancellor Rishi Sunak announced that thresholds at which employees and the self-employed would start paying national insurance contributions (NICs) would be aligned with the income tax personal allowance. Both were therefore raised from £9,880 to £12,570 per year. These thresholds would then remain at the same level until 2025/26, in alignment with the income tax thresholds.

In the Spring Statement, Rishi Sunak said raising the NICs thresholds 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.

Autumn Statement 2022

In the 2022 Autumn Statement, then Chancellor Jeremy Hunt announced the freeze of the income tax personal allowance and HRT, as well as the NICs thresholds, would be extended to April 2028 instead of ending in 2026. He also announced that the threshold at which employers start paying NICs (the ‘secondary threshold’) would be frozen at its current rate until April 2028. Additionally, he announced that the threshold at which people start paying the 45% rate of income tax (the ‘additional rate threshold’) would be decreased from £150,000 to £125,140.