What is Fiscal Drag
Fiscal drag is an economics term referring to a situation where a government's net fiscal position (equal to its spending less any taxation) does not meet the net savings goals of the private economy. This can result in deflationary pressure attributed to either lack of state spending or to excess taxation.
One cause of fiscal drag is the consequence of expanding economies with progressive taxation. In general, individuals are forced into higher tax brackets as their income rises. The greater tax burden can lead to less consumer spending. For the individuals pushed into a higher tax bracket, the proportion of income as tax has increased, resulting in fiscal drag.
BREAKING DOWN Fiscal Drag
Fiscal drag is essential a drag or damper on the economy caused by lack of spending or excessive taxation. As increased taxation slows the demand for goods and services, fiscal drag results. Fiscal drag is a natural economic stabilizer, however, since it tends to keep demand stable and the economy from overheating.
Fiscal drag has the effect of reducing (or limiting increase) in aggregate demand and becomes an example of a mild deflationary fiscal policy. It could also be viewed as an automatic fiscal stabilizer because higher earnings growth will lead to higher tax and therefore moderate inflationary pressure in the economy.
Because fiscal drag can operate as an economic stabilizer, fiscal drag can influence economic equality among citizens of the same region.
Fiscal Drag and Bracket Creep
As an example of the fiscal drag concept in action, consider a worker that gets a substantial pay raise that puts them over $30,000 per year. If the raise puts the worker into a higher tax bracket for income over $30,000, the higher earnings will result in the worker paying the higher rate of income tax and a higher percentage of their income being earmarked for income taxes.
Fiscal drag can also work in opposite direction. If there is deflation and falling wages, fewer workers would be in the higher tax bracket. Fiscal drag can be overcome by indexing tax brackets to earnings or inflation. However, this is not usually done.
Another example of fiscal drag is when wages go up by the rate of inflation, but tax brackets remain unchanged for long periods. In this situation, earners are eventually dragged up to the higher tax rates – even if a rising cost of living means they have not necessarily become financially better.