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As the Labour Party consolidates its position as the new government in 2024, many investors are wondering how their income and wealth might be affected. Will there be a slew of new “wealth taxes,” as many headlines warn? Or, could the economy – and taxpayers’ finances – benefit from a change in administration?
One little-understood area on this subject is “fiscal drag” and how it could undermine investors’ goals in the coming years (without careful planning). Below, we explain how the UK’s tax system could lead to higher tax bills for investors even without a change in government policy. We then explore some ideas to mitigate the impact on investors’ portfolios.
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The “hidden spectre” of fiscal drag
Fiscal drag occurs when wages go up over time. As income rises in a progressive taxation system (like the UK), more income enters higher tax bands. This can then create knock-on effects for savings and investments.
For instance, a Basic Rate taxpayer gets a Personal Savings Allowance (PSA) of £1,000 each tax year. However, if he gets a pay rise and suddenly enters the Higher Rate band, then his PSA is cut to £500 per year. Any interest he earns above this (now lower) threshold will be taxed at the 40% rate instead of 20%.
It does not necessarily take a promotion for someone to enter a higher tax bracket. Indeed, a simple yearly pay rise to keep up with inflation (as often occurs in the public sector) could eventually bring a taxpayer into a new income tax band – perhaps without even realising it.
The impact of ongoing tax “freezes”
The new Labour government (elected on 4 July 2024) has stated that it will continue the freeze on current income tax bands until April 2028. Given that the public finances are under considerable strain and the policy is expected to raise £33.5 billion a year, it seems unlikely that it will be dropped.
Indeed, there is a possibility that certain taxes may even go up in the coming years. In particular, capital gains tax (CGT) could be a target. No mention of it was made in the Labour manifesto, and CGT has been equalised with income tax in the past, even under Conservative governments (e.g. Chancellor Lawson in his 1988 budget).
The tax freeze has widely been described as a “stealth tax” because more workers will enter higher tax brackets in successive tax years as their pay goes up. From October to December 2023, for instance, average UK wage growth was 6.2%, but income tax bands stayed the same. Many of these workers will have entered a higher tax bracket.
Indeed, by 2029, an extra 3.7 million workers will have started paying income tax for the first time as their earnings cross over the tax-free Personal Allowance (£12,570). 2.7 million people will likely be pushed into the 40% Higher Rate, and 3.8 million people will be pushed into the 45% additional rate.
Without careful planning, this trajectory will have crucial implications for many investors who may face higher tax rates on their savings and investments.
Planning for fiscal drag
Fortunately for investors, it takes time for governments to implement tax changes and tax “freezes” are known far in advance. This allows flexibility for investors to navigate the UK’s shifting tax landscape with prudence and educated foresight.
A range of options are available to help investors generate tax-efficient returns. The ISA is a good first point of call. In 2024-25, an individual can contribute up to £20,000 per year to their ISAs and generate tax-free interest, capital gains and dividends inside. Labour has also committed to previous plans for a “British ISA”, which could expand this allowance by £5,000.
Business owners can also consider rebalancing their earnings-to-dividends ratios to achieve more optimal tax planning. In 2024-25, the additional rate for income tax is 45%, but 39.35% for dividend tax. Rebalancing towards the latter, therefore, could result in more take-home income. However, be careful to consider the wider implications for your financial plan with a specialist (e.g. when making mortgage applications).
Another option is to consider tax-efficient investments, such as the Enterprise Investment Scheme (EIS). EIS allows investors to claim 30% up-front income tax relief, and offers a range of other tax-efficient mechanisms such as “loss relief” and “capital gains tax deferral”. EIS opportunities are typically higher-risk than traditional equities, such as the London Stock Exchange stocks. However, the growth potential can be considerably greater.
Invitation
The UK already faces a high tax burden in 2024, which will likely become heavier as the government seeks to address the country’s numerous economic challenges. However, this does not mean that investors are destined to suffer. Careful planning can mitigate the impact.
Interested in finding out more about the exciting startup projects we have on offer to investors here at Bure Valley Group? Get in touch today to start a conversation with our team and discuss some of the great investment memorandums we have available here:
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