Fiscal drag happens when the government's net fiscal position (spending minus taxation) fails to cover the net savings desires of the private economy, also called the private economy's spending gap (earnings minus spending and private investment). The resulting lack of aggregate demand leads to deflationary pressure, or drag, on the economy, essentially due to lack of state spending or to excess taxation.
One cause of fiscal drag may be bracket creep, where progressive taxation increases automatically as taxpayers move into higher tax brackets due to inflation. This tends to moderate inflation, and can be characterized as an automatic stabilizer to the economy. Fiscal drag can also be a result of a hawkish stance towards government finances.
Many progressive tax systems are not adjusted for inflation. As wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate.
Suppose a person earns $20,000 per year and is liable to 20% tax on earnings above a threshold of $5,000 per year. Then they pay ($20,000–$5,000)*0.2 = $3,000 in taxes, or 15% of their income. Now suppose that due to inflation, their wage goes up by 5%, but the government only increases the tax threshold by 2%. They must now pay ($21,000–$5,100)*0.2 = $3,180 or 15.14% of their income as tax. Thus the proportion of the person's income that is paid as tax has increased.
- The Alternative Minimum Tax originally (1971) targeted 155 high-income households; based on 2004 law, it would affect 20% of households by 2010.
The U.S. federal surplus of the late Clinton years is an example of fiscal drag from declining spending in relation to taxes. During this time, large balance of payment deficits and private savings desires were not offset by government deficits, leading to insufficient demand in relation to economic production, slower economic growth, and lingering unemployment.
Real fiscal drag
Real fiscal drag takes place when tax thresholds are increased in line with price rises to avoid nominal fiscal drag, but where a growing economy means that earnings rise faster still, so increasing taxes as proportion of earnings.
Nominal bracket creep can easily be countered by a system of index-linked tax brackets, but this may be politically undesirable. Many voters do not perceive the effects of bracket creep, and so the government may prefer to adjust tax brackets manually once every few years: in effect, restoring the real tax rates to their approximate pre-inflation levels but in a way that gives the government the appearance that they are cutting taxes. Not surprisingly, such changes are usually made right before a general election is to be held.
Ireland is an example of a country in which, in recent years, the progressive income tax system has allowed government revenues to swell due to both nominal and real fiscal drag without either increases in the tax rates or decreases in the thresholds. That is because the country has experienced considerable economic growth, which some attribute to the low-interest monetary regime of the European Central Bank, resulting in high wage inflation. Whereas others attribute to the economic and educational policies of the Irish government, in subsidizing education and eliminating taxation of the arts, two historically low-income demographics that would thus respond strongly to an increase in income, resulting in price inflation and thus wage inflation to retain purchasing power parity.
- The Economist Economics A-Z: Fiscal drag
- Fiscal drag hits some taxpayers harder than others, new OECD study shows
- Fiscal Drag - An Automatic Stabiliser?, by Herwig Immervoll
- After the Death of Inflation: Will Fiscal Drag Survive?, by Friedrich Heinemann
- Tax bands, a chancellor's best friends, BBC News