Everything about Fiscal Drag totally explained
Fiscal drag refers to the process where tax thresholds are either not adjusted for inflation, or fail to keep pace with earnings growth, causing in either case an automatic rise in
tax revenues.
Example of nominal fiscal drag
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 (20000-5000)*0.2 = $3000 in tax, or 15% of 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 (21000-5100)*0.2 = $3180 or 15.14%. The proportion of income as tax has increased - this is fiscal drag.
Bracket creep
Bracket creep describes the process by which
inflation pushes wages and salaries into higher
tax brackets.
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 hasn't increased at all. The net effect is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate.
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.
Political dimension
Though nominal fiscal drag can easily be countered by a system of
index-linked tax brackets, this may be politically undesirable. Many voters don't perceive the effects of fiscal drag, 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're cutting taxes. Not surpisingly, 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. This 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 who would thus respond strongly to an increase in income, resulting in price inflation and thus wage inflation to retain
Purchasing power parity.
Further Information
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