What Is Fiscal Drag?

Fiscal drag is an economic term whereby inflation or income growth moves taxpayers into higher tax brackets. This in effect increases government tax revenue without actually increasing tax rates. The increase in taxes reduces aggregate demand and consumer spending from taxpayers as a larger share of their income now goes to taxes, which leads to deflationary policies, or drag, on the economy.

Key Takeaways

  • Fiscal drag is a result of decreased consumer spending as a result of increased taxation that eventually reduces aggregate demand, which leads to deflationary pressures.
  • Progressive taxation, whereby individuals are moved into higher tax brackets because of inflation or increased income, is a fiscal policy that results in fiscal drag.
  • Progressive taxation allows for increased government taxation without actually increasing taxes.
  • Fiscal drag can be seen as an automatic fiscal stabilizer as it controls a rapidly expanding economy from overheating.

Understanding Fiscal Drag

Fiscal drag is essentially a slowing in the growth of the economy caused by a lack of spending as increased taxation slows the demand for goods and services. When an economy is rapidly expanding, inflation results in higher income and therefore individuals moving into higher tax brackets and paying more of their income in taxes. This is particularly the case in economies with progressive taxes, or tax brackets, which stipulate that the higher income an individual makes the higher the tax they pay and thus they move into a higher tax bracket.

Moving into a higher tax bracket and paying a larger portion of income in taxes, as mentioned prior, results in an eventual slowing of the economy as there is now less income available for discretionary spending.

It is common to view fiscal drag as a natural economic stabilizer as it tends to keep demand stable and the economy from overheating. This is generally viewed as a mild deflationary policy and a positive aspect to fiscal drag.

Example of Fiscal Drag

John is a mechanic who earned $50,000 three years ago. In John's country, he is not taxed for the first $15,000 of his income. He is thus taxed on $35,000 at a rate of 20%, which is $7,000. In this scenario, John paid 14% of his income in taxes. $7,000 divided by $50,000.

In the present day, John is now making $65,000 and the additional $15,000 of his income is taxed at a rate of 35%. John's total tax cost is now $12,250, which is 18.8% of his annual income, an increase from the previous 14% and a larger portion of his total income.

In John's economy, the prices for most goods have risen at the same rate as his salary over the last three years. A larger portion of his income will now have to be used to pay for basic goods and he will have less income for discretionary spending. This will result in a drag on the economy if the same scenario were to be magnified across the population of John's country.