Income tax threshold freeze: How fiscal drag stages a stealth tax raid

The Chancellor has said the freeze on income tax thresholds will finally end from 2029.

The frozen thresholds have resulted in a colossal stealth tax raid in recent years. While neither Labour or the previous Conservative government have raised headline income tax rates, people will pay more in the coming years as thresholds fall behind inflation and wage rises.

The freeze was begun by Rishi Sunak in 2022 and although current Chancellor Rachel Reeves was expected to extend it, she announced in the Autumn Budget that it would stop after the 2028 to 2029 tax year.

This is good news but by then 'fiscal drag' will have affected workers for seven consecutive tax years. We explain what it is and how it raises money.

Income tax thresholds

Income tax is charged on earnings from employment and self-employment, but also on pension income, rental income and savings interest.

You don't usually have to pay income tax on all your taxable income because of tax-free allowances, namely the personal allowance.

The tax-free personal allowance means you do not pay income tax on anything earned between £0 and £12,570, but those earning more than £100,000 have this gradually removed.

The official tax rates for England, Wales and Northern Ireland are 20 per cent, 40 per cent and 45 per cent.

> How income tax works - and who forks out the most 

Tax bands

• The personal allowance means most will not pay any tax on the first £12,570

• Basic rate income tax at 20 per cent is then paid between £12,571 and £50,270

• Higher rate income tax at 40 per cent rate is paid between £50,271 and £125,140

• Additional rate income tax at 45 per cent is paid on income above £125,141

What does freezing income tax thresholds mean?

Income tax is an important revenue raiser for the Government, making up a quarter of the total tax taken every year.

Labour's manifesto committed to keeping income tax rates at their current level during the election, which means it couldn't raise the tax directly.

But the Chancellor can raise money through the back door by freezing income tax thresholds at their current level though.

This is because of something called fiscal drag. If allowances and thresholds don't rise with inflation or wages, the amount people can earn tax-free, or at a lower-rate, falls behind - and the government rakes in more cash.

As wages tend to rise over time, more low earners are caught in the tax net and the number of taxpayers in higher rate bands increases. 

Former Chancellors Rishi Sunak and Jeremy Hunt put this in place under the Conservative government and it will continue to be the case until April 2029. 

Fiscal drag in action

The effect of fiscal drag has been massive in recent years, due to high inflation. 

Total inflation has been 22 per cent on the consumer prices index since tax thresholds were last raised in April 2022.

The frozen basic rate threshold at £12,570 means more people have to pay income tax and the real value (adjusted for inflation) of the tax-free allowance is diminished.

Keeping the higher rate threshold at £50,270 also means that more people are paying more of their earnings in the 40 per cent bracket.

Similarly, the £100,000 threshold at which the personal allowance starts to be taken away hasn't increased in line with inflation. If it had, it would sit at roughly £153,000, after the previous Conservative government froze the thresholds in 2021.

A report by the IFS found that by 2027/28, 8.8million taxpayers will pay higher rate taxes, compared to 7.4million in 2023/24. 

The Office of Budget Responsibility forecast earlier this year that the freeze will raise £33.6 billion in the 2028/29 tax year. 

What do frozen thresholds mean for your savings?

Fiscal drag also affects savers and investors, dragging more of people's savings interest, dividend income and capital gains into tax.

This is because of our convoluted tax system which means that your income tax thresholds decides other allowances.

For example, interest on savings up to £1,000 per year is covered by the personal savings allowance for a basic-rate taxpayer.

You don't need to pay tax on savings interest until it exceeds your personal savings allowance, you will then pay your rate of tax on the sum above that. 

But if you're a higher rate taxpayer the threshold drops to £500 and you'll lose 40 per cent of any accumulated interest on your savings above that. And additional rate taxpayers get no personal savings allowance at all - and so pay 45 per cent tax on all of it.

This has become more important as savings rates have risen, meaning more people are affected even if they have smaller pots.  

This is why it is important to open a cash Isa so your savings are sheltered from any tax that would be incurred on interest.

> How to cut tax on savings interest  

Frozen thresholds also affect your investments if you hold any shares, funds or investment trusts that pay a dividend, or sell any investments to make a profit.

If you are a higher rate taxpayer you will have to pay extra capital gains tax or dividend tax. 

Capital gains tax rates were raised in the Budget, from 10 per cent to 18 per cent for basic rate taxpayers and 20 per cent to 24 per cent for higher rate taxpayers.

The tax-free allowance for dividend income was slashed to £500 from April 2024, down from £1,000 in the previous tax year. Before that it had been £2,000.

If your dividend income is higher than your personal allowance - which takes into account all your other taxable income too - plus your tax-free dividend allowance, you will pay dividend tax according to your income tax band.

Dividend tax rates are currently 8.75 per cent for basic rate taxpayers, 33.75 per cent for higher rate taxpayers and 39.35 per cent for additional rate taxpayers.

> How to cut the amount of dividend tax you pay

What do frozen thresholds mean for pensions?

Pesioners are also now being stung by frozen thresholds, largely because of the state pension triple lock, which ensures that it rises in line with inflation, earnings or 2.5 per cent.

This means that pensioners receiving the full state pension, which is currently £11,502.40, with some private pension income on top are likely to breach the personal allowance. They will then have to pay income tax.

Figures from HMRC show that more pensioners than ever are now paying tax, with over half a million more paying income tax between 2023/24 and 2024/25.

It means that there are now nearly 9million of those aged 65 and over paying tax on their income, nearly double the amount that paid it in 2010/11.

This is only set to increase in the coming years if the government continues its triple lock pledge.

The state pension will increase to £11,975 from next April, in line with September's earnings figure of 4.1 per cent.

It means that the state pension will only need to rise by 4.97 per cent to £12,570 the following year for the full state pension to breach the personal allowance.

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