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Income tax might seem straightforward earn more, pay more. But beneath the surface lies a complex system that's quietly costing UK taxpayers billions through a phenomenon called "fiscal drag." Whether you're employed, self-employed, or drawing rental income in Bolton, Manchester, or anywhere across the UK, understanding how income tax really works has never been more important.
What Is Income Tax?
Income tax is levied on all individuals regardless of age, covering earnings from employment, self-employment profits, property income, pension income, and interest. It's the government's largest revenue source HMRC estimates total income tax liability for 2024/25 at £303 billion, representing 35% of all tax collected.
For 2025/26, income tax becomes payable once your total income exceeds the personal allowance of £12,570. Above this threshold, you'll pay 20% on income up to £37,700, 40% on income between £37,701 and £125,140, and 45% on anything above £125,140.
Understanding Marginal Tax Rates
The headline rates don't tell the whole story. Your marginal rate the percentage paid on your next pound of income can be significantly higher. Between £100,000 and £125,140, the personal allowance gradually disappears, creating an effective marginal rate of 60%. When National Insurance contributions are included, this rises to 62%, meaning professionals can lose nearly two-thirds of additional earnings to tax.
What Is Fiscal Drag?
Fiscal drag occurs when tax thresholds remain frozen whilst wages rise with inflation. More people are pulled into paying income tax, and existing taxpayers find themselves pushed into higher rate bands—all without any change to the actual tax rates.
The personal allowance has been frozen at £12,570 since 2021/22 and won't change until April 2031 almost a decade without adjustment. The Office for Budget Responsibility estimates it would now be £15,480 had it increased with inflation, and there will be around 4.2 million more taxpayers by 2028/29 due to fiscal drag.
This "stealth tax" is a major revenue generator. The extension to 2031 is expected to raise an additional £8 billion. By 2029/30, fiscal drag will pull 780,000 more people into paying basic-rate income tax for the first time, along with 920,000 additional higher-rate taxpayers.
Recent Budget Changes
The Autumn Budget 2025 introduced further complications. From April 2027, separate tax rates will apply to property income: 22% basic rate, 42% higher rate, and 47% additional rate. Savings income faces similar increases. For landlords, investors, and those working through limited companies, these changes represent significant tax increases.
Taking Control of Your Tax Position
Strategic planning can minimize fiscal drag's impact. Maximizing pension contributions reduces taxable income, potentially keeping you in a lower band. Salary sacrifice arrangements for pensions or childcare reduce income before tax is calculated. Using ISA allowances shields savings from tax entirely, and couples should consider income splitting where possible.
Why Expert Tax Advice Matters
The complexity of the UK tax system has increased dramatically. Understanding marginal rates, planning around fiscal drag, and navigating different rates for different income types requires specialist knowledge.
At YRF Accountants, we help individuals and businesses across Bolton, Manchester, and the wider UK navigate this complex landscape. Our tax planning services identify opportunities to reduce your liability whilst ensuring full compliance with HMRC requirements.
Concerned about how fiscal drag affects you? Contact YRF Accountants today for a comprehensive tax review. Our experienced team will analyse your situation, identify planning opportunities, and provide clear guidance on minimizing your tax burden.
Frequently Asked Questions
Q: What is the personal allowance for 2025/26?
A: The personal allowance is £12,570 for most people. However, it reduces by £1 for every £2 earned above £100,000 and disappears entirely when income exceeds £125,140.
Q: Why is my marginal tax rate higher than 40%?
A: Between £100,000 and £125,140, you lose your personal allowance whilst paying 40% tax, creating an effective marginal rate of 60%. Add National Insurance and this becomes 62%.
Q: How does fiscal drag affect me?
A: Frozen tax thresholds mean wage rises push more of your income into higher tax bands. You pay more tax without rates changing—a stealth tax affecting millions of UK taxpayers.
Q: When will tax thresholds be unfrozen?
A: The personal allowance and main tax thresholds are frozen until April 2031. This represents almost a decade without adjustment for inflation.
Q: What can I do to reduce my income tax?
A: Maximize pension contributions, use salary sacrifice schemes, claim all available allowances and reliefs, use ISAs for savings, and consider income splitting with your spouse. Professional tax planning advice ensures you're using all available strategies.