How to avoid fiscal drag: practical tax strategies for higher earners

The UK has long been facing an economic slump. What was once considered a generous income is now barely covering basic living costs due to inflation. Yet, despite increasing wages attempting to keep up, high earners are still finding themselves falling more and more into the “squeezed middle”. This is largely attributed to fiscal drag – a stealth tax – which grows quietly in the background whilst allowing the government to stand by their pledge to not increase taxes. In this article we’ll explain how fiscal drag not only taxes more people, but also obtains more taxes from UK taxpayers, and what can be done to mitigate it, especially if you’re a higher earner.

What is fiscal drag?

Fiscal drag is the technical term used to describe the occurrence of when a country’s tax thresholds remain frozen at the same level over a period of time whilst inflation and wages continue to rise. What happens is that as people receive their pay increases, they edge closer and closer to the next higher tax bracket until they are “dragged” into paying higher tax rates.

Why is it often referred to as a stealth tax?

It’s known as a stealth tax as it allows the government to collect more taxes without having to increase tax rates. Generally, the personal allowance (the amount in which you can earn without being subject to income tax) rises, roughly in line with inflation so that there is a balance between how much things cost and how much tax you have to pay. However, if tax thresholds are frozen (including the personal allowance) this means that when pay increases due to inflation, more money will be subject to income tax.

The current personal allowance is £12,570 which was first set in 2021. According to the Bank of England inflation calculator, this would be the equivalent of £15,771 in 2026 but because the allowance has been frozen it means taxpayers are now paying tax on the £3,201 difference. So, whilst the government haven’t made any changes to tax rates, they’re still able to collect more taxes in the background, hence why it’s known as stealth tax.

Why is fiscal drag happening more and more in the UK?

It’s becoming ever more prevalent due to one of the longest periods in history where the income tax thresholds including the personal allowance has been frozen for. Whilst the £12,570 personal allowance was set in 2021 it was intended to stay frozen until 2026. Since then, there have been multiple extensions where in 2022 it was announced it would stay in place until 2028 and last year in 2025, it was further extended until 2031.  The Office for Budget Responsibility (OBR) predicts that the government will raise an addition £55.5 billion per year in taxes by 2030/31 simply through fiscal drag.

Who is most impacted by fiscal drag?

In truth, every taxpayer will be impacted especially as the cost of living continues to rise. However, some may notice it much more than others. Firstly, higher rate taxpayers, or those close to becoming higher rate taxpayers, are heavily impacted because not only do you then see a portion of your income being taxed at 40%, but you also begin to lose many financial benefits. This includes your personal savings allowance halving from £1,000 to £500, a clawback of any child benefit payments you may be claiming, and an increase in your capital gains tax rates and dividends tax rates. Those at the very top of the higher rate tax band are most at risk of falling into the effective 60% tax trap. This is where those earning over £100,000 begin to lose a portion of their personal allowance. For every £2 over £100,000, £1 from your personal allowance is lost which can mean you’re overall tax rate becomes a whopping 60%. You’ll lose your entire personal allowance once your earnings reach £125,140.

Pensioners will soon also feel the effects of fiscal drag more come April 2027. This is because their state pension is due to rise past the personal allowance for the first time as a result of the government’s triple lock promise. Those that rely solely on their state pension may find that they have to give some of it back because they receive more than the personal allowance which seems absurd, not to mention that they may have to face accountancy fees should they need help filing their self-assessment tax return. However, the government has responded to this and have provided temporary relief so that those whose sole retirement income is the state pension will not be required to pay income tax up until 2030. Nevertheless, this does not help those with modest private pension who already pay tax on their pension income.

Low earners and those earning the minimum wage may start seeing a part of their pay being taxed for the first time as the minimum wage is due to rise from £12.21 to £12.71 from April 2026. To illustrate the tax impact, say you worked 20 hours a week at the current £12.21 minimum wage. Your annual tax bill would be just £25.68 for the entire tax year (not accounting for national insurance contributions). However, when the minimum wage rises to £12.71, even where you continue to work the same 20 hours a week, your annual tax bill would rise to £129.68. This is a 400% increase in tax payment for only a 4% rise in hourly pay.

What can you do to avoid fiscal drag?

Although fiscal drag cannot be avoided entirely, there are several legitimate tax planning strategies that can significantly reduce its impact.

1. One of the most effective ways of protecting yourself from fiscal drag is through considered and forward-thinking pension planning. Pension contributions not only attract tax relief at your highest marginal rate, but for higher and additional rate taxpayers, they also reduce your adjusted net income — a crucial lever in managing exposure to key tax thresholds. This can be particularly valuable for those looking to remain below the £100,000 mark, where the tapering of the Personal Allowance begins, or to avoid charges such as the High Income Child Benefit Charge. For example, if you have earnings of £110,000, you will lose £5,000 of your Personal Allowance due to the taper. However, by making a £10,000 pension contribution, you can bring your adjusted net income back down to £100,000, thereby restoring your full Personal Allowance. In doing so, you are not only improving your immediate tax position, but also allocating £10,000 towards your retirement, with £2,500 of that effectively funded by the government through tax relief.
2. Charitable giving can operate in a similarly effective way, while also providing the added satisfaction of supporting causes that are meaningful to you. Donations made under Gift Aid extend beyond simple generosity; they are a legitimate and often underutilised tax planning tool. For higher-rate taxpayers, the gross value of a charitable donation reduces adjusted net income, which can have a direct impact on restoring lost allowances or avoiding additional tax charges. At the same time, the grossed-up donation extends the basic rate tax band, meaning a greater portion of your income is taxed at 20% rather than 40%. For instance, if you earn £105,000 per year, you will lose £2,500 of your Personal Allowance. By making a £5,000 net donation under Gift Aid (equivalent to £6,250 gross), you can reduce your adjusted net income to below £100,000, thereby fully restoring your Personal Allowance. In addition, your basic rate band is extended by £6,250, meaning more of your income benefits from the lower rate of tax. This combination of income reduction and rate extension makes charitable giving a uniquely powerful and tax-efficient planning strategy for higher earners.
3. Salary sacrifice schemes present a straightforward yet highly effective way of managing exposure to upper tax thresholds without necessarily foregoing overall value. Under such arrangements, employees agree to exchange a portion of their salary for non-cash benefits, which are typically more tax efficient. While declining a pay rise may initially seem counterintuitive, where that increase is redirected into a salary sacrifice arrangement, it can often result in a more favourable net outcome. Common benefits include enhanced pension contributions, access to electric vehicles under company schemes, and certain childcare support arrangements. Because the sacrificed salary is removed before income tax and National Insurance are applied, it reduces taxable income and can help keep earnings below key thresholds. For individuals on the cusp of higher or additional rate tax bands, this can be a subtle way of managing fiscal drag while still receiving tangible value.
4. For employees within growing businesses, particularly in the start-up and scale-up space, accepting an Enterprise Management Incentive (EMI) share option can offer a compelling alternative to traditional remuneration. As an HMRC-approved scheme, EMI options are structured to be highly tax-efficient. Provided certain conditions are met, there is typically no income tax or National Insurance to pay when the option is exercised — a significant advantage compared to non-approved share schemes. Instead, any eventual gain is subject to Capital Gains Tax (CGT) upon disposal of the shares, often at lower rates than income tax. Furthermore, if the relevant criteria are satisfied, Business Asset Disposal Relief may apply, reducing the CGT rate even further.
5. For company directors, regularly reviewing your remuneration strategy is essential. Many adopt a standard approach of taking a salary up to the Personal Allowance and extracting additional income through dividends. While this remains broadly tax-efficient, it is not universally optimal such as those looking to secure a traditional loan from a bank. As profits increase, failing to revisit this balance can result in a greater proportion of income being exposed to higher tax rates. Although dividend tax rates are generally lower than income tax rates, they still contribute to overall income levels and can push you into higher bands if not carefully managed. A more holistic approach, such as considering making your spouse or adult children shareholders to extract funds from your company could help mitigate fiscal drag for multiple people in your household.
6. The Marriage Allowance is often overlooked, yet it can provide a simple and effective way to optimise household tax efficiency. Where one spouse or civil partner has income below the Personal Allowance, they may transfer up to £1,260 of their unused allowance to their partner. This can reduce the recipient’s tax bill by up to £252 per year. While the relief is relatively modest in isolation, it becomes more meaningful when combined with other planning strategies. It is important to note, however, that this allowance is only available where the recipient is a basic rate taxpayer. If either partner falls into the higher or additional rate bands, the relief is no longer available. As such, careful planning around income levels and tax thresholds can sometimes preserve eligibility and maximise tax benefits.
7. While Individual Savings Accounts (ISAs) do not directly reduce taxable income, they play a crucial role in managing the longer-term effects of fiscal drag. ISAs provide a tax-efficient environment in which interest, dividends and capital gains can accumulate free from tax. Over time, as investments grow and compound within this wrapper, they do not contribute to taxable income and therefore do not increase exposure to higher tax bands. For higher earners who are already navigating multiple thresholds, this can be an invaluable way of building wealth without exacerbating their tax position. Ensuring that ISA allowances are fully utilised each year can form a key part of a broader strategy to insulate future income from the creeping effects of fiscal drag.
8. Finally, it is important not to overlook the opportunities available to generate income entirely tax-free. One of the most generous examples is the Rent a Room Scheme, which allows individuals to earn up to £7,500 per year from letting out a furnished room in their primary residence without incurring income tax. This can be particularly advantageous for those whose employment income sits close to a higher-rate threshold. For example, an individual earning £50,000 could generate an additional £7,500 through the scheme without breaching the higher-rate band, thereby avoiding any additional income tax liability. There are also smaller allowances available, such as the £1,000 trading allowance for casual or side income, but the Rent a Room Scheme remains one of the most impactful. Used strategically, these allowances allow individuals to supplement their income without increasing their exposure to fiscal drag.

Making the most out your finances despite fiscal drag

Fiscal drag is unlikely to disappear any time soon. With tax thresholds frozen and inflation continuing to influence wage growth, more taxpayers will find themselves pulled into higher tax bands over the coming years.

For higher earners, this makes proactive tax planning increasingly important. The right combination of pension contributions, investment planning and remuneration strategy can often soften the impact considerably.

While no strategy can eliminate fiscal drag entirely, thoughtful planning can ensure that more of your income remains working for you rather than being lost to an ever-expanding tax bill. If you are a company director, entrepreneur or higher earner concerned about how fiscal drag may affect your finances, reviewing your tax strategy with one of our professional advisers can be an important first step. With the right structure in place, it is often possible to reduce unnecessary tax exposure while continuing to grow your wealth over the long term. Simply get in touch today to book a consultation.