What is fiscal drag?
Fiscal drag occurs when inflation and earnings rise, but tax thresholds or tax bands do not increase with inflation. A progressive tax system – for example, income tax – pushes more taxpayers into higher tax brackets, meaning that tax revenues rise more than inflation. For instance, if the personal income tax allowance is £10,000, and the basic rate is 20%, then the income tax on someone earning £20,000 is £2,000. But if their income rises 10% to £22,000, their income tax increases 20% to £2,400. So ‘fiscal drag’ is a way that governments can raise revenues without raising the headline rate of tax.
The UK’s official forecaster, the Office for Budget Responsibility, assumes in its forecasts that most tax thresholds are maintained in real terms; that is, they rise in line with prices. In the case of income taxes, the government has to legislate if it wants to override that and keep them frozen or allow them to rise by less than inflation.
In his 2021 budget, then-chancellor Rishi Sunak announced that income tax thresholds would be frozen for four years, which took effect in April 2022. Higher inflation and rising earnings since then mean that this measure will raise more money than was forecast.