Fiscal drag

Fiscal drag is the effect of inflation and income growth moving taxpayers into higher tax brackets, leading to an increase in tax revenue without changes in tax rates, which can slow economic growth.
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Updated on Jun 14, 2024
Reading time 4 minutes

3 key takeaways

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  • Fiscal drag occurs when inflation or income growth pushes taxpayers into higher tax brackets, increasing their tax burden.
  • It can lead to higher tax revenues for the government without explicitly raising tax rates.
  • Fiscal drag can reduce disposable income and consumer spending, potentially slowing economic growth.

What is fiscal drag?

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Fiscal drag refers to the phenomenon where inflation or increases in income push taxpayers into higher tax brackets. This results in higher taxes being paid by individuals and an increase in overall tax revenue for the government, even though the tax rates themselves have not changed. Fiscal drag is a form of automatic fiscal policy that can subtly increase the tax burden on individuals, effectively reducing their disposable income and potentially dampening economic activity.

How fiscal drag works

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Fiscal drag occurs primarily due to the progressive nature of most income tax systems, where tax rates increase with higher levels of income. As nominal incomes rise due to inflation or economic growth, more of an individual’s income may be taxed at higher rates. This incremental increase in tax liability can result in a larger proportion of income being paid in taxes over time.

For example, consider a tax system with the following brackets:

  • 10% on income up to $20,000
  • 20% on income from $20,001 to $50,000
  • 30% on income above $50,000

If an individual’s income increases from $45,000 to $55,000 due to inflation, a portion of their income that was previously taxed at 20% will now be taxed at 30%. This shift increases the individual’s overall tax burden, even though the tax brackets themselves have not changed.

Impacts of fiscal drag

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Increased government revenue: Fiscal drag can lead to higher tax revenues without the government needing to raise tax rates. This additional revenue can be used to fund public services or reduce budget deficits.

Reduced disposable income: As taxpayers move into higher tax brackets, their disposable income decreases. This reduction in disposable income can lead to lower consumer spending, which can slow down economic growth.

Increased effective tax rates: Over time, fiscal drag can increase the average effective tax rate for individuals, making the tax system more burdensome.

Potential for bracket creep: Fiscal drag can cause “bracket creep,” where inflation pushes more taxpayers into higher tax brackets. This can create a perception of unfairness and reduce the incentive to work harder or earn more.

Managing fiscal drag

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Governments can take several measures to mitigate the effects of fiscal drag:

Indexing tax brackets: One common approach is to index tax brackets to inflation. By adjusting tax brackets annually for inflation, governments can prevent taxpayers from being pushed into higher brackets due to nominal income increases alone.

Tax relief measures: Implementing tax relief measures, such as increasing personal allowances or introducing tax credits, can help offset the impact of fiscal drag on taxpayers.

Periodic tax reforms: Regularly reviewing and adjusting the tax code can ensure that the tax system remains fair and efficient, reducing the unintended consequences of fiscal drag.

Examples of fiscal drag

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United States: In the U.S., tax brackets are indexed for inflation, which helps to mitigate the effects of fiscal drag. However, some components of the tax system, such as the Alternative Minimum Tax (AMT), have historically not been indexed, leading to bracket creep.

United Kingdom: In the UK, fiscal drag has been a topic of discussion as taxpayers have been increasingly pushed into higher tax brackets due to rising nominal incomes. The government periodically adjusts tax thresholds to address this issue.

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To further explore the concept and implications of fiscal drag, consider these related topics:

  • Progressive Taxation: Understanding how progressive tax systems work and their impact on taxpayers and the economy.
  • Inflation and Its Effects: How inflation influences income, purchasing power, and economic growth.
  • Bracket Creep: The specific phenomenon of taxpayers being pushed into higher tax brackets due to inflation.
  • Tax Policy: The principles and practices of designing and implementing tax systems.

Fiscal drag is an important concept in fiscal policy, highlighting the automatic effects of inflation and income growth on tax burdens. Exploring these related topics can provide a deeper understanding of how tax systems function and their broader economic implications.


Sources & references

Arti

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Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000 Invezz related data points, has read every piece of research, news and guidance we\'ve ever produced, and is trained to never make up new...