What a drag: the impact of frozen tax thresholds

Fiscal drag is created when governments freeze tax bands and pull more and more taxpayers into higher tax brackets. This stealth approach to increasing revenue tends to avoid the backlash that comes with overtly increased tax rates. When inflation is negligible the impact for taxpayers is generally easier to manage, but it is much harder to tolerate with inflation just under 11%. Using your reliefs and allowances in full is more important than ever.

Income tax thresholds

The personal allowance (£12,570) and the basic rate tax threshold (£37,700) are unchanged since 2021/22, and are now set to remain frozen until 2028. Other thresholds are subject to fiscal drag because the government simply ignores them from year to year.

• The £100,000 income limit at which the personal allowance starts to be withdrawn is unchanged since withdrawal was introduced in 2010. Personal allowance withdrawal leads to a 60% marginal tax rate, and an estimated million more taxpayers could be caught if nothing changes over the next five years.
• The high income child benefit charge income limit of £50,000 is unchanged since the charge was introduced in 2013. Around one in five families are now affected by the limit, compared with one in eight when the charge was first introduced.

In a similar vein, the lifetime ISA house purchase cap has remained at £450,000 despite increased property prices. Those locked out of using their lifetime ISA to buy their first home face a 25% charge if savings are reclaimed.

From 6 April 2023, the additional rate tax threshold is to be cut from £150,000 to £125,140; the point at which the personal allowance is fully withdrawn. As a result, some 230,000 taxpayers, who would not otherwise have done so, will pay the additional rate of 45%. The Scottish government has adopted the same approach, with the recent 2023/24 Budget seeing the top rate threshold reduced from £150,000 to £125,140, and other thresholds frozen at 2022/23 levels. However, the Scottish government has then gone further in adding an additional 1p to both the higher and top rates.

The changes increase the divergence between Scotland and the rest of the UK. For example, a Scottish taxpayer earning £50,000 will, for 2023/24, pay some £1,552 more in income tax.

Inheritance tax

One of the most marked examples of fiscal drag is the freezing of the inheritance tax (IHT) nil rate band which has been set at £325,000 since April 2009. As with income tax, the Autumn Statement has now extended the freeze to 2028. Combined with soaring property prices, it is no surprise that the government’s IHT receipts have nearly doubled in the ten years to 2021/22.

Inheritance tax bills can sometimes be mitigated with lifetime planning, although people should be careful not to leave themselves short of funds later in life.

The additional rate tax threshold is to be cut from £150,000 to £125,140; the point at which the personal allowance is fully withdrawn.

Tax planning

In the face of frozen thresholds, it is more important than ever to make the most of available reliefs and allowances.

• Some income tax planning may be possible for spouses and civil partners if income can be shared.
• Pension contributions can reduce the amount of income counting towards the various income limits.

If your income is expected to be less than £150,000 this year, but over £125,140 next year, look at bringing forward income into 2022/23 to avoid the additional rate next year. Contact us to discuss your options.