In last week’s Autumn Statement, Chancellor Jeremy Hunt announced a cut to National Insurance contributions from 12% to 10%. But, what benefit will that bring to you, and how much will be eaten up by the stealth tax freeze on income tax bands that is dragging more and more people into higher tax bands?
Despite mounting pressure to reduce income tax rates, Chancellor Hunt opted for a 2% cut to NI contributions for both employees and self-employed workers which will take effect from 6 January 2024.
Those on salaries of £30,000 are set to save £348, while those earning £40,000 are set to have £548 more in their pocket. Those earning £50,000 a year are making the maximum saving of £748 per year.
In the wake of rising taxes, which have reached their highest level in 70 years according to the Institute for Fiscal Studies, this NI cut comes as a welcome relief for many. However, the optimism surrounding the NI cut is tempered by the freeze on income tax thresholds (income tax bands and the tax-free personal allowance) until 2028. This freeze, identified as a stealth tax raid by the IFS, is expected to cost you hundreds of pounds annually.
What is Fiscal Drag?
Due to the income tax threshold freeze, many workers will have to start paying income tax for the first time or move up a bracket as incomes increase. This is what is known as fiscal drag.
Official figures (HMRC) show 4.2 million more workers now pay income tax of 20% compared to just three years ago. Meanwhile, 1.6 million more people have found themselves in the 40% tax bracket in the same period – and it’s all because tax thresholds were frozen in 2021.
The Government had traditionally used the September inflation figure to determine the personal allowance and income tax bands for the following April. This would have meant a 6.7% uplift in the amount taxpayers can earn tax-free and the same increase in the basic rate band before 40% income tax is due.
Instead, workers face another year with the same allowances following a freeze in the tax brackets until the 2027/28 tax year.
• The Personal Tax Allowance was £12,500 in 2019/20, increased to £12,570 in 2021/22 where it will remain until 2027/28.
• Had the government moved the tax bands in line with inflation, the personal allowance would currently be £14,270 and higher rate tax would begin at £57,170.
• If we assume the tax bands had increased by 2% over the last four years, someone earning £35k should be a further £308 better off.
Despite the benefits of the NI cut, the impact will be diluted by the frozen tax bands and fiscal drag, and those on the brink of the 40% tax bracket will be hardest hit. It is estimated that a fifth of workers will be paying the 40% rate by 2027 according to the Institute for Fiscal Studies.
The Hidden Tax Rises
Those hit hardest by fiscal drag are workers pulled into the 40% tax band as their income rises above £50,270; any pay rise would see all of it taxed at 40% rather than 20%.
On a 5% pay rise of £2,500 they would pay £1,000 in tax at 40% instead of £500.
If they got a bumper 10% pay rise, they would pay £2,000 in tax at 40% rather than £1,000.
In the first instance, they would see most of their £748 boost from the NI cut eaten up, and in the second instance, they would lose all of it and more.
With inflation still running high; the effect of huge price increases in food, heating, and cost of living in general over the last two years, workers are falling further and further behind in real cost of living income terms. Thanks to some wage growth, more people are being pulled into a higher tax bracket, but as inflation remains high, most workers are feeling less well-off over time.
How to Reduce Fiscal Drag
If you are pushed into a higher tax bracket, there are some options to reduce the amount of tax you pay - You need to be proactive to avoid fiscal drag stealthily sneaking up on you!
• Pension Contributions: Contributing to a pension scheme can reduce your taxable income, potentially lowering your income tax liability. Rather than paying a 40% rate of tax, you can utilise your pension…
For example, John gets a pay rise taking him from £50,270 gross annual pay (just below the 40% tax barrier) to £60, 270. After Income tax on the £10k pay rise, the net income gain is reduced to £6k….or John can ask his employer to put the full £10k in his pension. John’s future self will thank him!
• Salary Sacrifice Schemes: Some employers offer salary sacrifice arrangements, allowing you to exchange part of your salary for non-taxable benefits like childcare vouchers or cycle-to-work schemes.
• Making Student Loan Repayments strategically: Depending on your overall financial situation, you may choose to accelerate your student loan repayments or stick to the minimum required.
• Exploit other legal tax avoidance schemes.
Summary: You Won’t Feel Better Off
The NI cut is a promising increase to take-home pay for millions, however, the implications of frozen income tax thresholds, continued high levels of inflation, coupled with more energy price rises in January, means that ‘Real Household Disposable Income’ i.e. spare money that you have after paying the bills, is continuing to fall. According to the OBR:
1.11 Living standards, as measured by real household disposable income (RHDI) per person, are forecast to be 3½ per cent lower in 2024-25 than their pre-pandemic level. While this is half the peak-to-trough fall we expected in March, it still represents the largest reduction in real living standards since ONS records began in the 1950s.