Fiscal Drag in the UK Economy

Fiscal drag occurs when inflation and wage growth push taxpayers into higher income tax brackets or increase their tax burden without the government actively raising tax rates. This phenomenon leads to an increase in government tax revenue without explicit tax hikes, effectively reducing people's disposable income in real terms.

How Fiscal Drag Works

1. Inflation & Wage Growth: If wages rise due to inflation but tax thresholds remain unchanged or do not rise in line with inflation, more people end up paying higher rates of income tax.
2. Frozen Tax Thresholds: The UK government has frozen personal tax allowances and thresholds until at least 2028, meaning more people will be dragged into higher tax bands over time.
3. Stealth Tax Increase: Since tax bands are not adjusted for inflation, workers pay a larger share of their income in tax over time, even if their real purchasing power does not increase significantly.
4. Impact on Households: Middle-income earners, in particular, may find themselves paying the higher 40% tax rate as their salaries rise due to inflation.
5. Government Revenue Boost: Fiscal drag allows the government to collect more revenue without politically unpopular tax hikes.

UK Context in 2025

• The income tax personal allowance (the threshold before you start paying tax) is still frozen at £12,570.
• The higher rate (40%) threshold remains at £50,270, pulling more middle-income earners into the higher tax bracket.
• Inflationary pressures in recent years have led to wage growth, but fiscal drag means many are not feeling the benefits.
• The government benefits from increased tax revenues, potentially helping reduce borrowing or fund public services.

Why Fiscal Drag Matters

• Reduces disposable income, limiting consumer spending and slowing economic growth.
• Affects middle earners the most, increasing their tax burden.
• Acts as a hidden tax rise, making fiscal policy more restrictive without an explicit tax increase.