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Portrait of wet Labrador retriever on frozen lake| AccountingWEB| Is fiscal drag getting you down yet?
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Is fiscal drag getting you down yet?

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Are you finding fiscal drag, a drag? Whatever the outcome of the upcoming Budget, a discussion of the effects of fiscal drag is very likely to be on the agenda.

1st Mar 2024
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Louis XIV’s finance minister Jean-Baptiste Colbert is said to have declared that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing”. Over recent years, Chancellors have leaned heavily on the stealthy effects of fiscal drag, seeking to maximise tax revenues while keeping the hissing down.

Feeling the chill

Fiscal drag is usually discussed in the context of the freeze in the personal allowance and higher rate threshold. These were last uplifted in April 2022, when the personal allowance increased from £12,500 to £12,570 and the higher rate threshold increased from £50,000 to £50,270. These very modest increases were based on the then, much lower, Consumer Price Index (CPI) figures of 0.5% from September 2020.

The announcement that income tax thresholds would be frozen was actually made the year before in the 2021 Spring Budget. The then Chancellor Rishi Sunak announced that after the modest April 2022 increase, income tax thresholds would be held for four years until 2025-26. The intention was this freezing would be one of the measures to help the country balance the books after significant expenditure during the Covid-19 pandemic, while avoiding increasing tax rates directly. The latter course would have inevitably attracted hissing from some quarters. At the time, the measure was projected to bring in an extra £8bn a year by 2025/26.

In the 2022 Autumn Statement, Chancellor Jeremy Hunt extended the freeze by another two years to April 2028. Combined with similar NIC threshold freezes, the Office for Budget Responsibility (OBR) projected that these measures would bring in an extra £42.9m by 2027/28.

Default position

The freezes go against the default approach of increasing certain thresholds annually based on inflation, a process called ‘uprating’. With uprating, allowances such as the personal allowance are increased by the CPI each year. 

The uprating of certain tax thresholds was originally introduced in the Finance Act 1977 with cross party support. Although it does not apply to all thresholds, it is a useful way of ensuring tax allowances keep track of the ‘real’ value of money.

A stealth tax 

The shorthand approach to explaining fiscal drag is to focus on the effect for those crossing thresholds. The logic is that as wages rise over time, while rates are frozen, more people will start to earn more than the personal allowance and come into basic rate tax, while others are ‘dragged’ into higher rate taxes.

A point that is often missed is that the effect is still noticeable even if you don’t cross a threshold. A rate change is easy to see on a payslip, but a frozen threshold is not. To ‘see’ fiscal drag, it is necessary to look at your income tax as a percentage of total salary for one tax year and compare to the next. As long as your earnings are increasing, even if you don’t cross a threshold, over time thanks to fiscal drag your tax contribution will increase.

In 2023/24, the income tax charge on earnings of £35,000 (roughly the median annual earnings) was £4,486 – which equates to an average tax rate of 12.8%. A salary increase of, say, 6% to £37,100, still keeps the individual within basic rate tax, but their income tax bill is now £4,906 or 13.2% of their total salary. As the thresholds haven’t moved, all pay increases are fully subject to tax, and thus the percentage of salary going on tax increases.

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Replies (29)

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By Rob Swan
02nd Mar 2024 05:16

Thank you Helen. Jean-Baptiste Colbert.... so eloquent.
I fear the problem today is less to do with the amount of feathers, or the amount of hissing, but rather rather with the 'amount of deafness' from which the plucker is suffering. ATT, and many others, including institutions established by the Gov't. to safeguard and advise, may have 'called for...' and 'made representations....' but, if the plucker's deaf the goose may well end up with more than a plucking - it may be skinned alive!

Thanks (4)
Replying to Rob Swan:
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By OrmeGoat
04th Mar 2024 11:01

It's not just the goose which is plucked; we all are.

Thanks (2)
Replying to OrmeGoat:
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By johnjenkins
04th Mar 2024 11:06

The Tories goose has been well and truly cooked.

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Replying to OrmeGoat:
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By Rob Swan
04th Mar 2024 12:42

OrmeGoat,
That's the whole point of the analogy - the taxpayer is the goose. We (the ones who don't have a private trust in a tax haven) are getting skinned alive. That's exactly what the cost of living crisis is!

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Replying to Rob Swan:
Jason Piper
By Jason Piper
04th Mar 2024 11:06

Funnily enough that's exactly the basis of the (IIRC) Turkish equivalent saying, based on shearing sheep rather than flaying them. It's an image that's been increasingly prevalent in my thinking over the last few months, along with the "thermocline of trust" concept (google it along with the name "garius" if you're not familiar).

Thanks (1)
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By Open all hours
02nd Mar 2024 15:55

Along with net zero, low traffic neighbourhoods and 20 MPH zones it is having the intended effect of dragging us all
down.

Thanks (5)
Replying to Open all hours:
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By AthenaSolutions
04th Mar 2024 10:31

Indeed. We should continue to suffer from floods, famine, poor air quality leading to health issues, child deaths and injury in 30 mph zones as these all generate jobs and economic activity .

Thanks (7)
Replying to AthenaSolutions:
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By Open all hours
04th Mar 2024 13:40

Flood and famine are either in the hands of God or China. Air quality is far worse in a 20 zone. 30 limit was set when cars were much less safe than they currently are.
Guess you’re not on a bus that can’t now stick to the timetable, waiting for a care worker whose schedule has now become impossible or waiting for the ambulance as your pulse fades.

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Replying to Open all hours:
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By AthenaSolutions
04th Mar 2024 15:03

Less cars more buses?
Careworkers - rare beasts, those. The structural issues with the care sector don't need repeating.
Ambulances - don't think the 20 limit is the issue there.
Warning - i'm a car driver and a recreational cyclist, so of course i am biased!

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Replying to AthenaSolutions:
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By Open all hours
04th Mar 2024 15:48

The 20 limit is a huge issue for emergency services when combined with speed bumps. Costs scores if not hundreds of lives each year.
I am neither a driver or a cyclist if that is relevant.

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By AthenaSolutions
04th Mar 2024 10:29

The fiscal drag of VAT is something that is rarely discussed, yet has a pernicious effect on that threatened sector, micro enterprises and especially independent hospitality providers who recover a much smaller percentage of input VAT and for whom VAT is essentially a tax on turnover. The OBR has pointed out that freezing the VAT limit has pushed 169,000 more companies over the threshold, resulted in a significant "bunching" of companies just under the threshold with the resulting loss of economic activity, and added £1.4 BILLION a year to the Treasury. This is a massive fiscal burden on micro enterprises and strangles the seed growth of the economy. Why is this not discussed more?

https://obr.uk/box/the-impact-of-the-frozen-vat-registration-threshold/

Thanks (4)
Replying to AthenaSolutions:
Should Be Working ... not playing with the car
By should_be_working
04th Mar 2024 11:06

AthenaSolutions wrote:

The fiscal drag of VAT is something that is rarely discussed, yet has a pernicious effect on that threatened sector, micro enterprises and especially independent hospitality providers who recover a much smaller percentage of input VAT and for whom VAT is essentially a tax on turnover. The OBR has pointed out that freezing the VAT limit has pushed 169,000 more companies over the threshold, resulted in a significant "bunching" of companies just under the threshold with the resulting loss of economic activity, and added £1.4 BILLION a year to the Treasury. This is a massive fiscal burden on micro enterprises and strangles the seed growth of the economy. Why is this not discussed more?

https://obr.uk/box/the-impact-of-the-frozen-vat-registration-threshold/

Came here to make a similar comment.

I am now seeing more sole traders now going over the threshold 'unexpectedly' - in that we only find out when doing their tax return, which could conceivably be more than a year after the date when they should have registered. (Yes, of course we will have reminded them in the past about watching their turnover, but ...)

These days that doesn't just mean backdating a VAT registration but also now setting them up with an accounting system (even if it's just spreadsheets) which they may be ill-equipped skills-wise to handle. That it means more fees for us is small compensation for the headaches it can involve.

Thanks (4)
Replying to AthenaSolutions:
By Husbandofstinky
04th Mar 2024 11:11

Spot on. No doubt many agents out there are seeing this in the real world, all of which is stiffling growth.

The classic choice of charging customers 20% more and the risk of losing said customers, or taking the hit yourself. In the end, most compromise in order to try and remain competitive whilst a notable number deliberately maintain activity at just below the threshold. Nice one Chancellor.

Thanks (4)
Replying to AthenaSolutions:
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By petestar1969
04th Mar 2024 11:30

If the VAT registration limit was £20,000, every proper business would have to be register and all small businesses would be on an even playing field.

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Replying to petestar1969:
By Husbandofstinky
04th Mar 2024 13:08

That suggestion at more or less 'hobby' level of activities (£20k) would deter many the entrepeneurial consideration of 'going it alone'. The beaurcacy, the time and the cost of being VAT registered in order to acheive a meagre profit on £20k turnover.

As a bean counter I believe it would be detriment to the profession due to the net loss of revenue at my end of the spectrum despite some potential recoup on quarterly VAT Returns (No thank you).

Staying on the books would be the real world logical answer under these circmstances. An almost indirect anti capitalist ideal.

The goal posts have been there or thereabouts in all these years (as far as I can remember) for perhaps that reason.

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Replying to Husbandofstinky:
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By petestar1969
04th Mar 2024 15:57

Exactly my point. A business with turnover of less than £30,000 isn't really a proper business, so register if at least £20,000, maybe with one year of trading before registration to see if its worth the effort.

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Replying to petestar1969:
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By johnjenkins
04th Mar 2024 16:32

Unfortunately, for some, there is no alternative other than self-employment.

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By Yorkshireblue
04th Mar 2024 10:56

Tinkering with NI rates affects only those who pay it. Mr Hunt, I fear, is targeting pensioners who have benefited from the Triple Lock. There was a reluctance to award the increase and the Chancellor's NI rate shavings are forcing more and more pensioners into PAYE.
Is there an arguement for using NI rather than either PAYE rates or thresholds to deliver "budget cuts" to the wider population?

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Replying to Yorkshireblue:
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By Rob Swan
04th Mar 2024 12:45

Isn't it fair to say - these days - that NI is just more income tax?

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By petestar1969
04th Mar 2024 11:44

I struggle to understand how anyone can be paid (earn?) £12,570 and pay no income tax.

When I started my accountancy training my annual salary was £6,250 and the personal allowance was £3,450.....

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Replying to petestar1969:
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By johnjenkins
04th Mar 2024 11:53

When I started in 1965 I was paid the princely sum of £5 per week. I earned more from two part time jobs.

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Replying to petestar1969:
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By Yorkshireblue
04th Mar 2024 11:54

£735 per year when I started....earning just under £5k.

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Replying to petestar1969:
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By Rob Swan
04th Mar 2024 12:47

£3,450 ringa bell as my first annual salary... It's a long time ago ;)

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Replying to Rob Swan:
By Husbandofstinky
04th Mar 2024 13:10

£3200 (late 80's)

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Replying to petestar1969:
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By petestar1969
04th Mar 2024 14:00

Actually the PA was only £3,005 when I started......

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Replying to petestar1969:
paddle steamer
By DJKL
04th Mar 2024 15:19

1985 I started on a notional £4,000 pa but we only got paid £25 a week until we passed the three ICAS Prelim Exams (accountancy/tax/mathematical techniques) so circa 8-12 weeks on this rate from my start date in August (2 attempts then one lost the training contract)

It was slightly dispiriting as even with a Student Railcard bought during my last week at Aberdeen Uni it cost me £30 a week to commute Edinburgh-Glasgow (I only rented a room in Glasgow once I had passed the Prelims)

I think by the time I moved in 88 I was on about £6,600.

Sadly, somewhere in my rented storage unit will likely be my tax file with my P60s from that time

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Replying to petestar1969:
paddle steamer
By DJKL
04th Mar 2024 15:19

Duplicate deleted

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Replying to DJKL:
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By FactChecker
05th Mar 2024 18:11

When I wurra nipper ... I'd forgotten just how bad inflation was even in the 70s (not just the roaring 80s).
10 years before your first job, I bought my current house for 4x your 1st salary ... the trouble was that my salary at the time was less than 1/8th of the price, so I had to be creative with the mortgage application. Not so much lies as omitting the full story - like not stressing that I would be 'relying' on commission from 2nd & 3rd jobs to generate what they may have thought was a salary!

Fortunately in those days their ability/willingness to check was limited - and even more fortunately every time bankruptcy seemed to be looming I'd get another dollop of commission.
Enervating times, but what doesn't kill you makes you stronger!

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Replying to FactChecker:
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By johnjenkins
06th Mar 2024 10:24

Prior to the property crash 1st August 1988 (thanks to Geoffrey Howe) your home was your castle and lenders would lend willy nilly as they knew the value of the property would only increase. Then lenders panicked and repossessed many properties with good business going down the pan. I personally don't think we have ever recovered from that, purely because Major and Brown decided to stunt growth at the bottom end, thus stopping boom and bust. The problem is boom and bust naturally is good. The boom and bust we had with Miras was totally artificial.

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