Money Basics: What is fiscal drag?

More than two thirds of DIY Investors do not understand ‘fiscal drag’ – by Rob Morgan
 

The Chancellor’s Budget was particularly impactful for business owners who must absorb higher national insurance costs from April, as well as for wealthier families affected by a raft of measures around inheritance tax.

As these measures were relatively targeted, some may think they weren’t hit hard by the policies unveiled. But in her Budget announcement, Rachel Reeves chose not to extend the freeze on income tax thresholds beyond 2028, meaning many could get caught out by a process called ‘fiscal drag’.

Concerningly though, more than two thirds (69%) of DIY Investors do not understand what ‘fiscal drag’ means, which could drag people into paying more tax without realising.

What is fiscal drag?

Fiscal drag describes the scenario where the tax burden rises behind the scenes as incomes rise but tax bands don’t keep up or remain frozen. As income goes up, and inflation rises, a larger proportion of earnings falls into higher tax bands. A person effectively gets taxed more on the same earnings in terms of its spending power.

Research from Charles Stanley Direct found:

• More than two thirds (69%) of DIY Investors do not understand what ‘fiscal drag’ means.
  • This rises among women, with 80% of female investors not knowing what fiscal drag means, compared to 68% of men who don’t understand the term
• Half (50%) of DIY investors incorrectly identified the correct meaning of ‘fiscal drag’
  • 12% think that fiscal drag is when Government spending has to fall because of lower tax receipts
  • 11% said it meant that if earnings increase but inflation falls, consumers see ‘fiscal drag’
  • 9% think it means that taxes paid by consumers and businesses create a ‘fiscal drag’ on growth
  • 9% this it means that if bond markets plummet, this creates ‘fiscal drag’
  • A further 9% think it means that if a household income falls and moves down a tax bracket, that is ‘fiscal drag’
• One in five (20%) investors admit they simply do not understand what fiscal drag means

How can you beat fiscal drag?

1. Make pension contributions

If you are employed, a great way to counter fiscal drag is to make pension contributions. These receive pension tax relief, meaning you effectively claw back income tax. It means it only costs £80 to pay £100 into your pension for a basic rate taxpayer and £60 for a higher rate taxpayer.

2. Consider salary sacrifice

To make things even more efficient, consider making contributions via salary sacrifice if your employer allows it. This involves some of your salary going directly into your pension, with no tax deducted. Through this method you can save on national insurance as well as income tax, meaning it only costs £68 to pay £100 into your pension for a basic rate taxpayer, and £58 for a higher rate taxpayer. Our research found that 59% of DIY investors currently use or plan to use salary sacrifice. Of that, 29% say they use salary sacrifice to put them into a lower income tax bracket.

3. Make use of your ISA allowance

For investments and savings, using an ISA can shelter your returns from the taxman and ensure you don’t pay unnecessary tax, and if you are a couple with different levels of income, shifting cash or assets to the lower earner can also help minimise tax.

Methodology 

The research was conducted by Censuswide among 1,000 DIY Investors across the UK. Research conducted between 08.11.2024 – 12.11.2024. Censuswide abide by and employ members of the Market Research Society which is based on the ESOMAR principles and are members of The British Polling Council.

Rob Morgan is Chief Investment Analyst at Charles Stanley Direct