Fiscal Drag: The Stealth Tax Strategy Impacting Your Wallet

Fiscal drag occurs when tax thresholds are frozen, leading to increased taxable income without changing tax rates. This subtle mechanism results in higher tax revenues for the government as more taxpayers are pulled into higher tax brackets. Despite its unobtrusive nature, fiscal drag can significantly impact individuals, especially during periods of high inflation and earnings growth. And it is now raking in billions of extra £s of revenue into a Treasury desperate for higher tax revenues.

The Mechanics Behind Tax Thresholds

Governments set tax thresholds to determine at what income level individuals start paying taxes or move into higher tax brackets. Typically, these thresholds are adjusted annually in line with inflation through a process called uprating or indexation. However, when these thresholds are frozen, they do not keep pace with inflation or wage growth, resulting in fiscal drag.

Since April 2022, the UK has frozen several tax thresholds, a policy expected to last until April 2028. This freeze, particularly on income tax thresholds, is projected to generate over £33.5 billion annually by 2028/29.

Fiscal Drag: A Controversial Yet Practical Approach

The concept of fiscal drag has sparked debate.

On one hand, it is seen as a “stealth tax” because it increases tax revenues without altering tax rates, making it less noticeable to taxpayers. Critics, including think tanks like the Resolution Foundation and the Institute for Fiscal Studies, argue that relying on this method long-term can be problematic, especially as it erodes the real value of people's incomes during high-inflation periods.

Conversely, some experts, such as those from the Financial Times, acknowledge the necessity of such measures, particularly to offset costs like those incurred during the Covid-19 pandemic. The UK government highlights that despite the freeze, the personal allowance remains the highest in the G20, almost doubling since 2010.

Exam-Style Discussion Questions

1. Evaluate the arguments for and against the use of fiscal drag as a revenue-raising strategy during high-inflation periods.
2. Analyze the potential long-term economic consequences of freezing tax thresholds on middle and lower-income households.
3. Consider the role of fiscal drag in the broader context of fiscal policy. How does it compare to other forms of taxation in terms of economic efficiency and equity?

Glossary of Key Economic Terms

• Additional Rate Threshold: The income level at which the highest rate of income tax applies.
• Fiscal Drag: The increase in tax revenues resulting from inflation or income growth when tax thresholds are not adjusted accordingly.
• Indexation: The adjustment of income thresholds, benefits, or other financial benchmarks in line with inflation.
• National Insurance Contributions (NICs): Payments made by employees and employers in the UK to fund state benefits.
• Personal Allowance: The amount of income an individual can earn before paying income tax.
• Stealth Tax: A tax increase that occurs without changes to tax rates, often through mechanisms like freezing tax thresholds.
• Thresholds: Income levels at which different tax rates apply or at which tax becomes payable.
• Uprating: The process of adjusting thresholds in line with inflation or other indices to maintain their real value.

Retrieval Questions

1. What is fiscal drag, and how does it increase government revenue without changing tax rates?
2. What is the process called when tax thresholds are adjusted in line with inflation?
3. Since when have UK income tax thresholds been frozen, and until when are they expected to remain so?
4. How much annual revenue is the freeze of income tax thresholds expected to raise by 2028/29?
5. What was the significant change to NICs thresholds announced in the 2022 Spring Statement?
6. What did the 2022 Autumn Statement change about the additional rate threshold for income tax?
7. Why is fiscal drag sometimes referred to as a "stealth tax"?
8. What are the potential drawbacks of relying on fiscal drag as a long-term revenue-raising strategy?