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
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflation ...
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
A progressive tax is a tax in which the tax rate increases as the taxable amount increases.Sommerfeld, Ray M., Silvia A. Madeo, Kenneth E. Anderson, Betty R. Jackson (1992), ''Concepts of Taxation'', Dryden Press: Fort Worth, TX The term ''progre ...
increases automatically as taxpayers move into higher tax brackets due to
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
. 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.
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. People moving up to higher tax bracket but reduced spending.
Political dimension
Ireland
Ireland ( ; ga, Éire ; Ulster Scots dialect, Ulster-Scots: ) is an island in the Atlantic Ocean, North Atlantic Ocean, in Northwestern Europe, north-western Europe. It is separated from Great Britain to its east by the North Channel (Grea ...
is an example of a country in which, in recent years,{{when?, date=April 2019 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. That is because the country has experienced considerable economic growth, which some attribute to the low-interest monetary regime of the
European Central Bank
The European Central Bank (ECB) is the prime component of the monetary Eurosystem and the European System of Central Banks (ESCB) as well as one of seven institutions of the European Union. It is one of the world's most important centra ...
, 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 that 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 (PPP) is the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries' currencies. PPP is effectively the ratio of the price of a baske ...
.
References
The Economist Economics A-Z: Fiscal drag ttp://www.oecd.org/document/57/0,3343,en_2649_34533_40233913_1_1_1_1,00.html Taxing Wages 2006/2007: 2007 Edition OECD
The Organisation for Economic Co-operation and Development (OECD; french: Organisation de coopération et de développement économiques, ''OCDE'') is an intergovernmental organisation with 38 member countries, founded in 1961 to stimulate ...
.
Fiscal Drag - An Automatic Stabiliser? b
After the Death of Inflation: Will Fiscal Drag Survive? by Friedrich Heinemann
Tax bands, a chancellor's best friends BBC News
Fiscal policy