Fiscal drag hits savers as frozen thresholds double tax bills

Recent figures released by HMRC show a sharp increase in the number of individuals now paying income tax on their savings. But, it is not because they are saving more - and according to HMRC’s projections, that number will only continue to rise as more people get hit by fiscal drag. It is also basic rate tax payers who are most likely to be affected.

What is fiscal drag?

When tax thresholds and allowances are held while incomes or investment returns increase, fiscal drag occurs. As a result, more taxpayers are pulled into higher tax bands or become liable to tax for the first time, even though tax rates themselves have not increased. In real terms, this functions as a tax rise without the need for legislative changes to rates.

The number of basic-rate taxpayers liable for income tax on savings is expected to rise to approximately 1.19 million by 2026-27 - it was around 494,000 in 2022-23.

Over the same period, the number of higher-rate taxpayers paying tax on savings is forecast to increase from around 405,000 to 953,000, while additional-rate taxpayers affected are expected to rise from roughly 301,000 to 578,000.

These are substantial increases in a relatively short time period and reflect structural changes in the tax system rather than changes in taxpayer behaviour. This is fiscal drag in action.

In the UK, most income tax thresholds have been frozen in cash terms for several years. This policy has coincided with a period of higher inflation and, more recently, significantly higher interest rates. The combination means that more income - including savings income - is now falling within the scope of taxation.

The role of the Personal Savings Allowance

The Personal Savings Allowance (PSA), introduced in 2016, allows basic-rate taxpayers to earn up to £1,000 of savings interest tax-free each year, while higher-rate taxpayers can earn up to £500. Additional-rate taxpayers are not entitled to any savings allowance. These limits have not changed since the allowance was introduced.

When the PSA was set, interest rates were close to historic lows, and many savers earned little or no taxable interest. As a result, relatively few people exceeded the allowance. However, the interest rate environment has changed significantly since then. With deposit rates now far higher than in the late 2010s, even modest cash balances can generate enough interest to exceed the allowance.

For example, a basic-rate taxpayer with £50,000 in savings earning 2% interest would receive £1,000 of interest and remain within the allowance. At 5% interest, the same savings produce £2,500 of interest, leaving £1,500 potentially subject to income tax. No change in tax policy is required for the taxpayer’s liability to increase because the change arises purely from higher returns combined with fixed thresholds.

Why more ordinary savers are affected

One notable feature of the HMRC data is that the largest increase is among basic-rate taxpayers. This suggests that the impact is not confined to higher earners or wealthy investors, but is increasingly affecting individuals with relatively modest savings balances.

Several factors are contributing to this trend. First, higher interest rates have increased the amount of taxable income generated from cash deposits. Second, frozen income tax thresholds mean more people are classified as higher-rate taxpayers, reducing their savings allowance from £1,000 to £500. Third, demographic changes, including an ageing population with accumulated savings, mean that more individuals rely on interest income as part of their overall finances.

Pensioners in particular may be affected. Many retirees hold significant cash balances for security or income purposes and higher deposit rates can quickly push their interest income above the PSA. Because pension income and savings interest are both subject to income tax, the interaction of frozen thresholds and rising returns can result in unexpected liabilities.

A tax rise without changing rates

From a policy perspective, the increase in taxpayers paying tax on savings is a clear example of how fiscal drag operates in practice. Governments can increase tax revenues by freezing thresholds rather than raising rates, which may be politically easier but has similar economic effects.

The Office for Budget Responsibility has repeatedly noted that threshold freezes are expected to increase the overall tax burden as a share of national income over the coming years. While this applies across the tax system, the effect on savings income is particularly visible because the Personal Savings Allowance has remained unchanged despite a very different interest rate environment from the one in which it was introduced.

For taxpayers, the practical implication is that allowances which once seemed generous may now be exceeded much more easily. Individuals who previously had no need to consider the tax treatment of their savings may now need to monitor interest income more closely or consider using tax-efficient wrappers such as ISAs to avoid unexpected liabilities.

Looking ahead

Unless allowances are increased or interest rates fall significantly, the number of people paying tax on savings income is likely to continue rising. The HMRC projections suggest that the trend is already well established, and it illustrates how fiscal drag can affect a wide range of taxpayers over time.

While no single policy change is responsible for the increase, the combination of frozen thresholds, higher rates of return, and unchanged allowances has materially expanded the scope of the tax system.

Monahans can help you to make the most of your tax allowances so that you can minimise your tax liabilities. Contact our tax team for more information.

Dominic Bourquin