Understanding fiscal drag

You may not have seen a change in tax rates, but if your pay has gone up, you could still be paying more tax. This is known as fiscal drag.

Fiscal drag happens when tax thresholds stay frozen while wages rise. Over time, more of your income is taxed, or taxed at higher rates, even though the headline rates haven’t changed. That’s why it’s often called a “stealth tax”.

In the UK, the personal allowance (£12,570) and higher rate threshold (£50,270) have been frozen since 2021 and are now expected to stay frozen until 2031. As pay rises continue, more people are being pulled into higher tax bands or paying income tax for the first time.

What this means for you

• A bigger share of pay rises go to tax
• More people become higher rate taxpayers over time
• Those earning over £100,000 may feel the impact most, as the personal allowance is gradually withdrawn (no Personal Allowance on taxable income over £125,140), creating a higher effective tax rate in this range.

What can you do about fiscal drag?

Fiscal drag is a policy effect – you can’t opt out of it. However, there are legal and practical steps that can help reduce its impact.

1. Make use of pensions and salary sacrificePension contributions reduce your taxable income. With salary sacrifice, contributions are taken before income tax and National Insurance are calculated, lowering both.
2. Use ISAs to protect savingsISAs don’t reduce your taxable income, but they shelter savings and investment growth from income and capital gains tax. This becomes more valuable if fiscal drag pushes you into higher tax bands, where the Personal Savings Allowance falls from £1,000 to £500 (and to £0 for additional rate taxpayers).
3. Check your tax codeAn incorrect tax code can lead to over or under payment of tax. Common reasons include benefits in kind, untaxed income, or corrections for earlier underpayments. It’s good practice to review your code each tax year via your payslip or HMRC account.
4. Consider Marriage AllowanceIf one partner earns less than the personal allowance and the other is a basic rate taxpayer, up to £1,260 of unused allowance can be transferred, reducing tax by up to £252 a year. Claims can be backdated for up to four years.

In summary

Fiscal drag doesn’t feel like a tax rise, but over time it quietly increases how much tax many people pay. Understanding how it works, and how it affects your pay, can make it easier to plan and make informed decisions about saving, pensions and future income.