Fiscal drag
From Free net encyclopedia
Fiscal drag refers to the increase in tax revenue caused when the threshold of a tax is not increased in line with inflation.
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Example of 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 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.
Real fiscal drag
Real fiscal drag takes place when tax thresholds are increased in line with price rises, 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 do not 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 pre-inflation levels, but in a way that makes the government seem like they are giving the taxpayer an additional benefit.
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 fiscal drag (both nominal and real) without either increases in the tax rates or decreases in the thresholds. This is because the country has experienced considerable economic growth under the low-interest monetary regime of the European Central Bank, resulting in high wage inflation.