When it comes to managing personal or business finances, there are many terms that can sound complicated or obscure. Fiscal drag is one of them and it is being used a lot lately in anticipation for the Autumn Budget —and while it may seem like technical jargon, understanding it is essential. Fiscal drag affects your tax obligations and your take-home income in ways that can quietly reduce the financial benefits of pay raises or other income increases.
In this post, we’ll explore what fiscal drag is, why it happens, and what steps you can take to protect your finances.
What is Fiscal Drag?
Fiscal drag occurs when inflation or wage growth pushes people into higher tax brackets, resulting in a higher tax bill. This can happen even if your real income—meaning the value of your income after adjusting for inflation—hasn’t actually increased.
In other words, even if you’re earning more in nominal terms (the number on your payslip), if everything you buy is getting more expensive, your ability to buy goods and services might not have improved at all. Yet, thanks to tax thresholds that don’t adjust with inflation, you could be paying a higher rate of tax, which eats into your take-home pay.
For example:
Imagine you’re earning £45,000, and you receive a pay rise to £50,000. This sounds like a nice boost, right? However, if that increase pushes you into a higher tax bracket- Which it does in Scotland, you’ll now pay a higher percentage on part of your earnings.
The end result? A significant portion of your “raise” is lost to higher taxes, leaving you with less disposable income than you’d expect.
Why Does Fiscal Drag Happen?
Fiscal drag can happen due to two main factors:
Inflation: When prices rise, the buying power of your income decreases. Without adjustments to tax thresholds, more people end up in higher tax brackets simply because their salaries increase to keep up with the cost of living.
Wage Growth: As wages grow over time (even modestly), more people find themselves pushed into higher tax brackets. Without tax brackets adjusting accordingly, many taxpayers face a higher tax burden, effectively reducing the real value of their income growth.
Governments can allow fiscal drag to take place as a subtle way to increase tax revenue without explicitly raising tax rates. By not adjusting tax brackets in line with inflation, they can collect more tax from a population whose nominal incomes are rising, even if their real income remains flat.
How Does Fiscal Drag Affect You?
For individuals and families, fiscal drag can make it harder to improve financial wellbeing, even if incomes rise. A salary bump that pushes you into a higher tax bracket may not add as much to your take-home pay as you’d hoped, thanks to the increased tax on that additional income.
For business owners, the effects of fiscal drag can be equally impactful. As costs rise due to inflation, companies often raise wages to retain employees. However, employees might not feel the full benefit of these increases due to higher taxes, leading to dissatisfaction and more pressure on businesses to increase wages further.
In both cases, fiscal drag silently erodes purchasing power, making it more challenging to stay financially ahead.
Steps to Minimise the Impact of Fiscal Drag
While we can’t entirely avoid fiscal drag, there are ways to reduce its impact on our finances through smart planning and strategies. Here are a few tips to consider:
Optimise Your Tax Allowances and Reliefs
Take full advantage of available tax allowances and reliefs. For instance, using your ISA allowance, pension contributions, or any available business deductions can lower your taxable income and help reduce the impact of fiscal drag.
Consider Salary Sacrifice Options
If your employer offers a salary sacrifice scheme (for things like pensions, childcare vouchers, or company cars), this can be a tax-efficient way to keep more of your income. These schemes reduce your taxable income, which can keep you in a lower tax bracket or minimise the additional tax liability on a pay rise.
Review Income Sources and Tax Bands
For those with multiple income streams, such as dividends, rental income, or a second job, reviewing your income sources can be helpful. You may be able to restructure how you’re paid to optimise your tax position and avoid unnecessary hikes in your tax rate due to fiscal drag.
Seek Professional Advice
Navigating tax strategies can be complicated, especially as tax laws change. Consulting an accountant or tax advisor can help you identify effective ways to optimise your finances, manage tax obligations, and ultimately reduce the effects of fiscal drag on your income.
Final Thoughts
Fiscal drag is an often-overlooked aspect of personal and business finance, but its impact can be significant over time. As prices rise, so do incomes, and without adjustments to tax thresholds, more individuals will find themselves facing higher tax bills that reduce the benefit of earning more.
By understanding fiscal drag and implementing smart tax strategies, you can protect more of your income, making it easier to achieve your financial goals. If you’re wondering how fiscal drag may be affecting your financial situation or would like to explore strategies to minimise its impact, feel free to get in touch—We are here to help!
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