A pay increase is normally good news. However, a higher salary does not necessarily translate into an equivalent increase in the amount available for you to spend or save.

Inflation, tax thresholds, and progressive tax rates can all influence how much of an increase in income is ultimately retained.

One of the mechanisms behind this is known as fiscal drag.

What is fiscal drag?

Fiscal drag occurs when incomes rise faster than tax thresholds, resulting in a greater proportion of earnings becoming subject to tax or falling within higher tax bands.

The extent of fiscal drag depends largely on three factors:

1. Tax thresholds and allowances 
2. Inflation and rising living costs 
3. Earnings growth relative to those thresholds

In some tax systems, thresholds are indexed or uprated, meaning they increase periodically in line with a measure such as inflation. This can help reduce the effects of fiscal drag. Where thresholds instead remain unchanged or ‘frozen’, their real value gradually falls as prices and earnings increase.

The overall proportion of income paid in tax can therefore increase without any change to headline tax rates. For this reason, fiscal drag is sometimes described as a ‘stealth tax’, as tax revenues can increase without rates formally being raised.

The role of inflation

When the cost of goods and services rises, wages will often increase over time as businesses seek to maintain employees’ purchasing power. However, a 5% increase in salary does not necessarily represent a 5% improvement in someone’s financial position.

If that higher nominal salary causes more income to become taxable or subject to a higher tax rate, disposable income may increase by considerably less than the headline pay increase. After allowing for higher living costs, real spending power could potentially decline.

This is also sometimes referred to as bracket creep, as rising nominal incomes gradually move taxpayers through a progressive tax system.

Does fiscal drag affect everyone equally?

The effect of fiscal drag can differ depending on an individual’s level of income:

• For lower earners, an unchanged tax-free allowance represents a progressively smaller proportion of a rising salary, meaning more of their income becomes taxable. 

• For middle and higher earners, rising salaries can push additional income across tax thresholds and into higher tax bands.

Research suggests that lower and middle earners can be particularly exposed, especially where their finances are more dependent on employment income.

For example, where wages are rising in response to inflation, the combination of higher living costs and a greater tax burden can mean that even after receiving a pay rise, real purchasing power may remain unchanged or potentially decline.

Conversely, those with higher incomes or greater accumulated wealth may have more diverse sources of income and capital, which can be subject to different allowances, rates and tax treatment depending on the jurisdiction.

They may also have greater flexibility over how and when income or capital is accessed, as well as greater scope to make use of pension contributions, tax-efficient investments and other available planning opportunities.

Two households experiencing similar growth in income or wealth may therefore face different outcomes depending on the source of that growth, how their finances are structured, and the allowances and planning opportunities available to them.

Why is it called fiscal ‘drag’?

Fiscal drag does not only affect an individual’s tax bill. The ‘drag’ refers to its potential effect on the wider economy.

As incomes rise, a greater share may be collected in tax, leaving households with less additional disposable income to spend. Across the economy, this can slow growth in consumer spending and reduce demand for goods and services.

For this reason, fiscal drag can act as an automatic stabiliser. During periods of strong economic and income growth, higher tax revenues can help moderate demand and reduce the risk of the economy overheating, without requiring an increase in headline tax rates.

What does this mean for financial planning?

A rising income is generally positive, but the headline figure only tells part of the story.

Changes in earnings can affect tax liabilities, disposable income, savings capacity and the value of available allowances. This can influence decisions around pension contributions, investment planning, retirement income and the timing of withdrawals from different assets.

Making effective use of available allowances, deductions, pension arrangements and other tax-efficient strategies can therefore form an important part of financial planning, depending on individual circumstances and the relevant tax jurisdiction.

At Patterson Mills, we consider these factors alongside your wider income, investments, pensions and long-term objectives to help structure your finances as efficiently as possible. 

If you would like to review how your wider financial arrangements could be structured more effectively, get in touch with us today and book your initial, no-cost and no-obligation meeting.

Send us an e-mail to contactus@pattersonmills.ch or call us direct at +41 21 801 36 84 and we shall be pleased to assist you.