We have all become familiar with the concept of ‘fiscal drag’ - the government being sneaky in its tax hikes. Instead of changing the rates we pay, it chooses not to raise tax allowances in line with earnings or inflation, so that we all pay more but in a less obvious way.
When Rishi Sunak was chancellor, he used fiscal drag like a sledgehammer, freezing the income tax thresholds, inheritance tax allowance and lifetime allowance for four years until April 2026. Last week, chancellor Jeremy Hunt took a leaf out of Sunak’s book and added another two years to the total, meaning that income tax and inheritance tax thresholds will now stay the same until April 2028. The lifetime allowance was not tampered with this time - more on that later.
With everybody screaming ‘stealth tax’ from the rooftops as an additional £25bn is added to the tax bill, the fact that taxpayers are going to feel the Autumn Statement pain is hardly a secret. But it can be harder to translate that into individual figures.
The biggest impact will be on income tax. Freezing the thresholds for two more years may not seem like much when they were already frozen until 2026. But as our earnings grow, the longer the freezes remain in place, the more the effect is magnified by reverse compounding. Assuming a fairly conservative 3 per cent annual wage growth rate, Quilter calculates that somebody on £90,000 in the 2022-23 fiscal year will be £377 worse off next year… but £2,869 worse off in 2027-28. In five years, the threshold freezes will cost them a cumulative £7,013, of which some £4,706 is in the final two years.
This calculation does not take inflation into account. When earnings growth was keeping up with or beating inflation, a fiscal drag trick was to adjust the thresholds based on inflation rather than on wages, to save a bit of cash. But now, until inflation is under control or wages catch up, the real term wage decline adds to the pain.
The inheritance tax threshold and the lifetime allowance don't impact as many people, but it is here that we can see clearly what the fiscal drag does to taxes when governments keep it going for a long time.
Interactive Investor calculates that the £325,000 inheritance tax (IHT) threshold, introduced in 2009, would be worth £464,643 in today’s money, had it been inflation-adjusted every year. People leaving property to their children or grandchildren can avail themselves of a further £175,000 allowance, a measure that was introduced in 2017.
Even so, HMRC data shows that IHT receipts for April 2022 to October 2022 increased by 14 per cent year on year. In 2021-22, receipts were at their highest level on record, both in nominal terms and as a percentage of GDP. Strong house price growth and stock market performance have led to more people paying more inheritance tax.
The figures for the lifetime allowance are even starker. The allowance has been bumped up and down a few times and is currently at £1,073,100, frozen until 2026. The original £1.5mn cap, introduced in 2006, would be worth more than £2.3mn in today’s money – its absence means a real-terms reduction of £1.2mn. Hunt has left it alone for now, but arguably the damage has already been done.
