Fiscal drag

Fiscal drag

Fiscal drag refers to the process where tax thresholds are either not adjusted for inflation, or fail to keep pace with earnings growth, causing in either case an automatic rise in tax revenues.

Example of nominal 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.

Examples

  • The Alternative Minimum Tax originally (1970) targeted 155 households; based on 2004 law, it would affect 20% of households by 2010.

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 approximate pre-inflation levels, but in a way that gives the government the appearance that they are cutting taxes. Not surpisingly, such changes are usually made right before a general election is to be held.

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. This is because the country has experienced considerable economic growth, which some attribute to the low-interest monetary regime of the European Central Bank, resulting in high wage inflation. Whereas others attribute to the economic and educational policies of the Irish government, in subsidizing education and eliminating taxation of the arts, two historically low-income demographics who would thus respond strongly to an increase in income, resulting in price inflation and thus wage inflation to retain Purchasing power parity.

References

Taxing Wages 2006/2007: 2007 Edition, OECD.

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