fiscal drag - Example of fiscal drag, Real fiscal drag, Political Dimension

The effect of inflation on tax revenues. If tax allowances are not kept in line with inflation, individuals pay relatively higher amounts of tax, thus dragging down post-tax incomes; consequently the demand for goods and services falls.

Fiscal drag refers to the increase in tax revenue caused when the threshold of a tax is not increased in line with inflation.

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. 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 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 both nominal and real fiscal drag without either increases in the tax rates or decreases in the thresholds.