In today's discussion, we delve into the concept of "Fiscal Drag" and its profound implications for UK taxpayers. This term, though not commonly discussed, holds significant relevance for our financial well-being. Fiscal Drag occurs when inflation drives up prices and wages, yet the government fails to adjust tax thresholds accordingly. Consequently, taxpayers find themselves pushed into higher tax brackets, leading to increased tax liabilities. We'll explore why understanding Fiscal Drag is crucial for taxpayers and how it impacts our financial landscape.

Explaining Fiscal Drag

Fiscal Drag is a phenomenon that often goes unnoticed but has far-reaching effects on our finances. It occurs when inflation outpaces adjustments to tax thresholds, resulting in taxpayers being pushed into higher tax brackets. As incomes rise, individuals may find themselves transitioning into higher tax bands, subject to increased

tax rates

. This silent tax hike can significantly impact disposable income, leading to financial strain for many households.

Understanding UK Tax Bands

Within the UK tax system, individuals are categorized into basic, higher, or additional rate tax bands. The shifting tax landscape presents challenges for taxpayers striving to maintain financial stability. With frozen allowances failing to keep pace with inflation, taxpayers face higher tax burdens without a corresponding increase in real income. This can have detrimental effects on household budgets and overall financial well-being.

Implications and Challenges

The implications of Fiscal Drag are significant, affecting taxpayers across the board. Despite efforts to combat rising tax liabilities, many individuals find themselves grappling with reduced disposable income and higher tax burdens. This often goes unnoticed by many but has tangible effects on household finances. The challenges posed by Fiscal Drag underscore the importance of proactive tax planning and strategic financial management.

Combating Fiscal Drag through Tax Planning

Effective tax planning offers a strategic approach to mitigate the impact of rising tax liabilities. By leveraging legal strategies such as pension contributions and charitable donations, taxpayers can optimize their tax positions and minimize liabilities. Proactive measures can lead to significant savings and financial resilience in the face of Fiscal Drag. By understanding the implications of rising tax liabilities and implementing smart tax strategies, we can ensure a more secure financial future.

Conclusion

In conclusion, Fiscal Drag poses a significant challenge to UK taxpayers, affecting their financial stability and disposable income. However, proactive tax planning empowers individuals to navigate through these challenges and safeguard their financial well-being. By understanding the implications of rising tax liabilities and implementing smart tax strategies, we can ensure a more secure financial future. We encourage listeners to engage in discussions and share their experiences with tax planning strategies. Together, we can navigate the complexities of the tax system and achieve financial resilience.

Fiscal drag. Is that a term that you often raise in conversation? I doubt it. It's a term though, that has got more prevalence, more meaning though for us as UK taxpayers. In today's I Hate Numbers podcast, I'm going to go through what fiscal drag actually is. I'm going to go through why it's important for us as UK taxpayers to get to grips with it.

more importantly, what the impact is on the tax that we pay. And how with smart tax planning, we can navigate our path through that. In this week's podcast, I'm going to focus on the impact, some of the general things that we can do to try and mitigate the pain to our financial bank balances. And in next week's podcast, I'm going to go through more prescriptive methodologies that we can use to start to navigate the impact of fiscal drag.

You're listening to the I Hate Numbers podcast with Mahmood Reza. The I hate numbers podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now here's your host, Mahmood Reza.

Well let's start with the basics. When you hear that word, that term fiscal drag, what does it come drop in your own minds? What exactly is it? Well, it's that perfect storm of when prices rise, inflation takes its effect, prices rise for goods and commodities, wages rise, but the government doesn't actually adjust the personal tax thresholds that we as UK taxpayers are entitled to.

So by the law of unintended or potentially intended consequences, your taxpayer bracket will shift for circumstances outside of your control and where you might pay one level of tax, you end up paying a higher rate of tax. Let's add some context and perspective. Now in the United Kingdom, we operate for income tax purposes on what's called tax bands. And there are three current bands in operation. There's a basic rate band, there's a higher rate band and there's an additional rate band as well as our wages go up as we generate greater profits as our income levels rise to keep pace with inflation or because we've had to put prices up. What tends to happen is we generate more paper wealth, we generate more income but unfortunately the consequence of that is that we get pushed into higher tax brackets.

We don't actually see a net increase in our income, but we will be paying more taxes as a consequence. Now I want to explore this idea of the different tax bands at the moment. The three bands are as follows: the basic, the higher and the additional rate. Now for the purposes of the podcast, I don't want you to lose the will to live by throwing loads of numbers at you.

So we're going to work on approximations of numbers here. The full details can be found in the attached notes. Let's start with a basic rate band. Now basic rate band means that if an individual has income up to and including 50, 270 pounds odd, then any income within that limit is taxed at the basic rate, which is currently 20%.

The income typically will be your gross wages, profits from any rental property, self-employed income, any dividends that you extract from your company or from elsewhere, interests and the like. Once it goes over that 50, 000 odd pounds, then you start to pay an extra level of tax. So currently, basic rate taxpayers will pay 20% on that. Now we're not talking about national insurance here, by the way, we're talking about income tax.

Now the next jump up into the higher rate bracket, currently up to the 23/24 tax year end, i.e., the 5th of April 2024. When you've got 150, 000 pounds of income in total, anything over the basic rate band will be taxed at the 40 percent rate. And you're known as what's called a higher rate taxpayer. So if somebody is on, for example, an 80,000 salary, some of that income they earn will be tax free.

That's your personal allowance of 12.500 pounds approximately. The rest of it up to the 50 is taxed at 20%. Anything over that up to the 80,000 will be taxed at 40%. Now the next band is what's called additional rate. And that's where currently up to the 5th of April, 2024, once your income goes into the 150,000 pound plus two things you observe will happen.

Number one, any income in excess of that figure, you'll pay 45 percent tax on. So in the UK, we've got three tax rates, 20, 40 and 45. The rates we pay will depend on where our income falls into those bands. One thing to watch out for folks, by the way, 6th of April 2024, the additional rate band drops from 150 odd to 125,000.

So whereas before, you wouldn't have paid that additional rate tax, you're now going to pay it once you get to 125 odd thousand pounds. That's a real squeeze financially. Now that's income tax. Now allowances are also frozen in other areas. Now the capital gains tax allowance is being cut in the 23/24 tax year is cut to six and in 24/25 is cut to three.

More of that in a future podcast episode, now from a business perspective also there is an impact. Current VAT registration threshold is 85,000 over a 12-month rolling basis. That's frozen. And because of the push on cost pressures, where businesses have had to put their prices up or put in their price up naturally, you're likely to trip into that VAT registration limit earlier than you would expect.

The VAT threshold is not intended to be changed for some time. So again another example of fiscal drag. Now let's come back to fiscal drag as it applies to income tax. Now this is a bit like a silent tax hike. It's under the surface, those allowances that are frozen, and they're going to be frozen by the way for a number of years, will mean that you will walk into that higher rate tax band.

The tax band takes a bigger slice. It's a bit like taxation through the back door. The personal allowances aren't upgraded now to keep pace with inflation, let alone, you have less disposable income and the tax take is much higher as a result. Estimates are the equivalent of freezing those allowances has put about four pence on the rate of income tax.

Now that's the situation we find ourselves in, but there is a way to combat and to deal with fiscal drag and that's by some tax planning. Now tax planning, and we're talking about avoidance and not evasion, evasion is what gets you serving time at Her Majesty's pleasure at worst case, or certainly being subject to penalties, that's where you understate income, overstate expenses, hide income, we're not into that at I Hate Numbers.

Tax planning is about finding the smart strategies to legally reduce and minimise your tax burden. Now some practical tips, now this is not going to be overextended with lots of tips on how to do tax planning. That's going to be explored later on. So for example, having private pension schemes or having an occupational pension scheme at work.

Pension contributions reduce the amount of income that's subject to tax. It has the rate of increasing your personal tax band and therefore, even though pensions can be considered very positive and very good for future retirement, it also has an impact on the amount of tax that you pay. Other things as well, charitable donations.

Not only are you doing good things, but also you're lowering your tax bill. So more particularly if you are in that higher or additional rate tax band and you make those donations to charity, but you're not claiming for them. It's an idea to revisit because that will save you some tax and you can claw that back. If you're thinking about making that decision to donate to a charity, many people in my experience don't donate to a charity because of tax breaks, but it's something that might push you over the edge to actually making that financial donation to a charity of your choice. It's going to be dealt with under the auspices of gift aid. Now these are general tips.

We need to be aware of them. You may be thinking about other investments that you can make in ISA accounts, a great way for tax planning. Now with that in mind folks, we've got fiscal drag, what it is, we are going to be dragged, I'm using that term very loosely, into paying more tax because inflation has effectively not kept pace with our allowances that we can have those allowances that we're entitled to are eroded, they have less monetary value and therefore you're going to end up paying more tax as a consequence. So that is something that we're seeing your control in a sense of doing some taking some action, perhaps mitigation the plan. So good tax planning, good support there can actually help minimise that burden that you face.

Folks, I hope you found this useful. I'd love it if you could share it with those who will get some benefit. What's your own thoughts here? Are you somebody who's feeling the squeeze? Are you somebody who actually thinks that actually a bit of careful tax planning may help me? If so, let me know. And until next time, happy fiscal dragging.

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