Taking the drag out of fiscal drag

5 minute read

Question: What did UK chancellor Rachel Reeves do in her 2025 Autumn Budget that looks set to bring in the most cash into the Treasury’s coffers?

Answer: Nothing.

The largest single revenue-raising measure announced in the Budget was not a hike in the rate of a particular tax or the removal of a popular allowance or relief. Instead, by doing nothing and keeping the freeze on personal tax thresholds in place for a further three years, the chancellor is expected to raise £8bn in 2029–30 and £13bn in 2030–31 (Institute of Fiscal Studies - IFS).

The alchemy at work here is known as fiscal drag — by freezing thresholds, inflation and earnings growth will drag more people into the taxpaying net and more into paying higher rates of tax.

Fiscal drag in numbers

Personal tax thresholds, which previously rose, for the most part, in line with CPI (Consumer Price Index) inflation, have been frozen in cash terms since April 2021. Increasing these in line with the prevailing CPI rate in each of the intervening years shows how thresholds would have been considerably higher than they are today:

	Current level	Theoretical level if increased by CPI
Personal allowance	£12,570	£15,714
Higher rate threshold	£50,270	£62,845

In 2021, the OBR (Office for Budget Responsibility) estimated £8bn a year would be raised by 2025/26 because 1.3m more people would be paying tax and a further 1m would be paying the higher rate. The impact is cumulative and compounds over time. By 2027/28, the freeze is expected to see an additional 3.2m people paying tax with 2.6m more paying the higher rate.

By extending the freeze for a further three years to 2030–31, the overall effect is projected to be a 5.2m increase in the number of taxpayers and a 4.8m increase in the number of higher rate payers (IFS).

At the individual level, the table below shows how much extra income tax and national insurance will be paid, assuming 3% inflation and 5% wage growth:

Earnings	Income tax		National Insurance
	Cost 28/29	Cost 29/30	Cost 28/29	Cost 29/30
£25,000	-£76	-£153	-£30	-£61
£39,863	-£76	-£153	-£30	-£61
£50,000	-£377	-£766	£60	£122
£75,000	-£377	-£766	£60	£122
£100,000	-£977	-£1,984	£60	£122
£125,000	-£414	-£840	£60	£122
£150,000	-£414	-£840	£60	£122

A matter of optics

The amount raised by the threshold freeze is equivalent to a 1% increase in all rates of income tax. And yet, although a 1% increase in income tax rates would have raised relatively more from high earners and less from working people, the fiscal drag route was chosen. The reason, it seems, to enable the chancellor to claim she has kept to the letter of the Labour Party’s 2024 General Election Manifesto — that Income Tax and VAT rates as well as National Insurance contributions (NICs) would not be increased. Politics appears to have usurped economics.

Whether it’s freezing thresholds or raising tax rates, the effect is the same, more people stand to pay more income tax. There are, however, steps that can be taken to soften the blow.

Pension relief, for now

Pension contributions through salary sacrifice are one option. These are currently efficient for income tax, employer and employee national insurance but, as announced in the Budget, from 6 April 2029, only the first £2,000 of pension contributions through salary sacrifice each year will be NIC efficient. Contributions through salary sacrifice will still benefit from tax relief at one’s highest marginal rate of tax. And a reduction in salary, irrespective of whether there is a NIC saving can help preserve child benefit and, for those with incomes above £100k, help preserve free childcare and the personal allowance. Until the cap comes into force, salary sacrifice can reduce the impact of fiscal drag and, even then, it will continue to have a role to play.

Wrapping up

And then there is the matter of what happens to income after it has been earned. More than ever, individuals should give careful consideration to how they manage their personal finances and how they own their wealth. This allows for future tax liabilities to be minimised, something seemingly all the more important after the Budget included a 2% tax increase on savings income, property income and dividends. There was, however, no increase to the rates of capital gains tax, the maximum remaining at 24%, the same for higher and additional rate taxpayers. The same principles apply for wealth held within trusts.

Wrapper selection plays a key role here. Many wrappers are available, each offering their own set of tax benefits.

The Individual Savings Account (ISA) remains an important financial-planning tool, despite the planned reduction in the annual ISA cash limit to £12,000 for under 65s from 6 April 2027. The overall annual ISA limit will remain at £20,000.

Corporate structures, such as Family Investment Companies (FICs), are increasingly being considered for succession planning – FICs appear to be unaffected by the aforementioned 2% tax increase on savings accounts, property income and dividends. As for investment bonds, onshore bond internal life fund taxation will be impacted, with the tax credit on a chargeable event enhanced to reflect this. Offshore bonds are also subject to savings income tax on chargeable events but are great vehicles for deferring tax.

Doesn’t have to be a drag

Choosing the optimal wrapper that matches an individual’s specific needs and circumstances is key. Professional advice ought to be sought. By talking to an expert and putting in place a financial plan that works for the individual and utilises available tools and wrappers, fiscal drag doesn’t have to be…a drag.

Investments and the income from them can go down as well as up, you may not get back what you invest. This material is not tax, legal or accounting advice and should not be relied on for tax, legal or accounting purposes. Quilter Cheviot Limited does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting adviser(s) before engaging in any transaction.