Fiscal drag
Encyclopedia
Fiscal drag happens when the government's net fiscal position (spending minus taxation) fails to cover the net savings desires of the private economy, also called the private economy's spending gap (earnings minus spending and private investment). The resulting lack of aggregate demand
leads to deflationary pressure, or drag, on the economy, essentially due to lack of state spending or to excess taxation.
One cause of fiscal drag may be bracket creep, where progressive taxation increases automatically as taxpayers move into higher tax brackets due to inflation. This tends to moderate inflation, and can be characterized as an automatic stabilizer to the economy. Fiscal drag can also be a result of a hawkish stance towards government finances.
pushes wages and salaries into higher tax bracket
s.
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.
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.
The US Federal surplus of the late Clinton years is an example of fiscal drag from declining spending in relation to taxes. During this time, large balance of payment deficits and private savings desires were not offset by government deficits, leading to insufficient demand in relation to economic production, slower economic growth, and lingering unemployment- i.e. the 90's boom came to an end.
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
.
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
leads to deflationary pressure, or drag, on the economy, essentially due to lack of state spending or to excess taxation.
One cause of fiscal drag may be bracket creep, where progressive taxation increases automatically as taxpayers move into higher tax brackets due to inflation. This tends to moderate inflation, and can be characterized as an automatic stabilizer to the economy. Fiscal drag can also be a result of a hawkish stance towards government finances.
Bracket creep
Bracket creep describes the process by which inflationInflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
pushes wages and salaries into higher tax bracket
Tax bracket
Tax brackets are the divisions at which tax rates change in a progressive tax system . Essentially, they are the cutoff values for taxable income — income past a certain point will be taxed at a higher rate.-Example:Imagine that there are three tax brackets: 10%, 20%, and 30%...
s.
Many progressive tax systems
Progressive tax
A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. "Progressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate...
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
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 governmentGovernment
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
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.
- The Alternative Minimum TaxAlternative Minimum TaxThe Alternative Minimum Tax is an income tax imposed by the United States federal government on individuals, corporations, estates, and trusts. AMT is imposed at a nearly flat rate on an adjusted amount of taxable income above a certain threshold . This exemption is substantially higher than the...
originally (1970) targeted 155 high-income households; based on 2004 law, it would affect 20% of households by 2010.
The US Federal surplus of the late Clinton years is an example of fiscal drag from declining spending in relation to taxes. During this time, large balance of payment deficits and private savings desires were not offset by government deficits, leading to insufficient demand in relation to economic production, slower economic growth, and lingering unemployment- i.e. the 90's boom came to an end.
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 bracket creep 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 bracket creep, 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 surprisingly, such changes are usually made right before a general electionGeneral election
In a parliamentary political system, a general election is an election in which all or most members of a given political body are chosen. The term is usually used to refer to elections held for a nation's primary legislative body, as distinguished from by-elections and local elections.The term...
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
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...
, 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
Purchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
.