It has been really pleasing to see the reduction in the rate of inflation in both the UK and US. Wage growth remains robust and whilst this helps with the cost of living increases we have all encountered the pain of fiscal drag will continue to bite on both incomes and estate values.

What is fiscal drag?

Fiscal drag is the ‘unintentional’ increase in tax burdens on individuals due to inflation and rising incomes. This phenomenon occurs when tax thresholds, exemptions, and allowances do not keep pace with inflation and wage growth. In the UK, fiscal drag has been a subject of concern and debate, as it can have significant implications for individuals, businesses, and the overall economy.

Fiscal drag typically occurs when tax thresholds remain static or increase at a rate slower than inflation and wage growth. In the UK, individuals are subject to various taxes, including income tax, national insurance, and IHT. As the cost of living rises and wages increase, individuals may find themselves pushed into higher income tax brackets or subject to higher tax rates, even if their real purchasing power has not improved.

One key component of fiscal drag in the UK is the income tax system. The government sets thresholds for each tax band, and when these thresholds are not adjusted in line with inflation, more individuals may find themselves in higher tax brackets. This can result in a situation where individuals experience a reduction in their disposable income, despite earning more in nominal terms.

Effects on inheritance tax

Often the other more contentious areas for fiscal drag is inheritance tax. The nil rate band of £325,000 has remained at this level since the 2009/10 tax year. The residence nil rate band was introduced in 2017 which increased the IHT exempt element of estates up to a maximum of £500,000 each. The increase in RPI since April 2005 has been in excess of 75%, the potential maximum IHT free level has significantly lagged the inflationary increase seen over the period.

How will individuals and the economy be impacted?

Fiscal drag can have several implications for individuals and the broader economy. One of the immediate effects is a reduction in consumers’ purchasing power, as more of their income is allocated to taxes. This can lead to decreased consumer spending, which is a significant driver of economic growth.

In the long term, fiscal drag can contribute to a negative cycle. Reduced consumer spending may lead to slower economic growth, which, in turn, can impact businesses, employment, and government revenue. As businesses struggle, they may cut back on hiring and investment, further exacerbating economic challenges.

Government management

Governments must carefully manage fiscal policy to mitigate the impact of fiscal drag. We have the Autumn Statement coming next week and it will be interesting to see what Jeremy Hunt says in this area. If recent years are anything to go by we may see no increase to tax thresholds and the paid of fiscal drag will continue to bite harder each year.

All of this though provides some really good planning opportunities. Things like pension contributions to reduce income to lower thresholds can result in really attractive contribution relief percentages, as high as 60%. What a boost to pension savings if you can get a 60% tax leg up at outset!

We will be watching the Autumn Statement closely to see the detail and how this affects our clients.

Thanks for reading and #enjoythejourney