A recent report from the Financial Times has indicated that Chancellor Rachel Reeves may extend the freeze on Income Tax thresholds.
This will likely be announced in the Budget on 30 October.
While Labour has committed to not raising the basic, higher, or additional rates of Income Tax, extending the freeze to 2030, first implemented by the previous Conservative Government, would still have consequences for taxpayers.
Although not technically a tax rate hike, this decision has been criticised for creating a ‘stealth tax’ on individuals and businesses alike.
What are the current Income Tax thresholds?
As it stands, the current thresholds for Income Tax in the UK are:
- Personal allowance – £12,570 (the amount you can earn before paying any Income Tax)
- Basic rate (20 per cent) – Income between £12,571 and £50,270
- Higher rate (40 per cent) – Income between £50,271 and £125,140
- Additional rate (45 per cent) – Income above £125,140
These thresholds are currently frozen until 2028, but Chancellor Reeves is expected to announce an extension to this freeze for another two years, taking it to 2030.
The ‘stealth tax’ and fiscal drag
By not adjusting these thresholds for inflation or wage growth, more people will be dragged into higher tax bands as their incomes increase over time.
This is known as fiscal drag, and it can profoundly affect individuals and businesses.
The Institute for Fiscal Studies (IFS) estimates that an additional 400,000 people will be pulled into paying Income Tax, with 600,000 more entering higher tax bands if the freeze is prolonged.
The impact on individuals
For individuals, fiscal drag will likely lead to:
- More people moving into the higher and additional rate tax bands
- Inflation reducing the value of the personal allowance
- Reduced disposable income, which can affect spending and savings habits
The impact on businesses
While fiscal drag primarily affects individual taxpayers, businesses will also feel the impact indirectly
To help employees keep up with rising living costs, businesses may need to increase wages.
However, as those wage increases push employees into higher tax bands, the value of the pay rise diminishes, leading to dissatisfaction and further pressure on employers to raise wages again.
Should National Insurance thresholds also remain frozen, businesses could face higher employer National Insurance contributions as employee wages increase.
There has already been talk of employer National Insurance contributions increasing, so this could have a larger impact on businesses.
With individuals experiencing reduced disposable income due to higher taxes, businesses may see reduced consumer spending, which could affect sales and profitability.
What can be done to mitigate fiscal drag?
There are steps that both individuals and businesses can take to mitigate the impact of fiscal drag.
Tax-efficient savings and investments
Individuals can make use of tax-efficient savings vehicles, such as ISAs and pensions, to reduce their taxable income.
Maximising pension contributions, for example, not only provides long-term savings benefits but also reduces the amount of Income Tax paid in the current year.
Salary sacrifice schemes
Employees can consider salary sacrifice schemes for pensions, childcare, or other benefits, which can reduce their taxable income and help mitigate the effects of fiscal drag.
Tax planning for businesses
Businesses can look at strategic tax planning, including how to manage wage increases and employer contributions effectively.
Our team of accountants can help you with advice on these matters to help alleviate some of the financial pressure fiscal drag places on businesses.
Government sources have suggested that extending the freeze on Income Tax thresholds would not breach Labour’s election promises, as their manifesto specifically pledged not to increase the Income Tax rates, rather than the thresholds.
However, this freeze could generate an additional £7 billion per year for the Treasury by 2030, helping to plug the estimated £40 billion fiscal shortfall.
If you are worried about how fiscal drag could affect your personal or business finances, please contact us today for expert advice.
