Fiscal Drag

The fiscal drag is a situation wherein taxpayers or consumers become liable to pay more taxes due to increased income or rising inflation. Thus, a fiscal drag controls the economy's consumer spending and aggregate demand by automatically increasing the government's tax revenue. 

The fiscal drag concept explains an automatic increase in government tax revenues due to rising inflation or income levels. It occurs without the government increasing tax rates. Thus, the fiscal drag effect assists in cooling the overheating of an economy by limiting aggregate demand and, thereby, economic growth as a result of progressive taxation.

• A fiscal drag explains the automatic increase in government tax revenues or drag due to inflation or increasing economic incomes. 
• An economic slowdown due to fiscal drag or increased taxes leads to a cooling effect on the economy that was overheating due to inflationary pressures and high aggregate demand.
• For instance, increased taxation due to progressive tax rates stabilizes the spending by consumers by reducing their disposable or discretionary income. It has a deflationary effect on the entire economy.
• It also reduces the fiscal deficit and improves fiscal health.

A fiscal drag and its effect are visible in an economy with increasing inflation and rising incomes due to economic growth. As a result, certain sections of society tend to move into higher tax brackets due to progressive taxation. Thus, the fiscal drag effect increases the tax revenue for the government without an actual increase in tax rates. 

An increase in taxable incomes results in an automatic cooling of an overheating economy that limits aggregate demand and reduces discretionary spending. It mitigates the situation of too much money running after too few goods. Consequently, fiscal drag has a deflationary outcome that moderates the inflationary pressure on the economy.

However, certain fiscal policy measures, such as progressive or higher corporate taxes, also drag tax revenues for the government. For example, in the case of progressive taxes, higher or increasing incomes attracts a higher tax rate on the taxpayers.

The increasing tax rates on the increase in income also affect economic slowdown. This slowdown is due to the reduced discretionary and leisure spending income available for individuals and households. Consequently, there is a reduction in aggregate demand and output levels, thus reducing the inflationary pressures within the economy. This cooling-off process also brings price relief to consumers.

A fiscal drag results in increased tax revenues for the government, reducing its high fiscal deficit and improving fiscal health. The government can continue to provide welfare subsidies, especially to the poorer sections, in times of rising inflation. These subsidies can cover health insurance, reduce drug prices for senior citizens, and provide relief from high prices to very low-income households.

Let us understand some more features of fiscal drag with the help of a few examples below, 

Example #1

For instance, Caroline is a citizen of the U.S. who is currently earning between $80,076 to $170,050, and thus, she becomes liable to pay 24% tax on her income.

However, when she earned a lower salary between $41,776 to $89,075, she was obligated to pay a tax rate of 22%. Similarly, for the first $10,275 of her income, a tax rate of 10% will apply to her earnings. Thus, it shows that with an increasing income, the tax rate progresses accordingly. This increase in the taxation rate automatically reduces Caroline's disposable income. As a result, she cuts down on some of her expenses.

Thus, a higher income attracts a higher tax rate. As a result, it leads to fiscal drag or an automatic increase in the government's tax revenue with increasing incomes.

Example #2

The U.S. government has recently passed the Inflation Reduction Act of 2022 to tame the soaring inflation and relieve senior citizens from the high drug prices. This bill targets some necessary measures to control inflation. Such as providing subsidies to certain sections of the citizenry through subsidies to cover health insurance. 

As a fallout of rising inflation and, thereby, demand for higher wages, the increased liquidity or money in the hands of the people has pushed prices further, making them unaffordable for some. Thus, the fiscal drag in this situation has had a limited effect on pulling back the rising inflation. 

The fiscal drag explains a situation of increasing government tax revenue due to rising inflation and, thus, rising incomes. Consequently, more taxpayers fall into higher tax brackets and become liable to pay higher taxes. Thus, fiscal drag and inflation reduce the economy's disposable incomes and discretionary spending.

The government's fiscal deficit reduction is a major outcome of a drag in fiscal tax revenues resulting from progressive taxation or increased tax rates.

A fiscal cliff refers to a situation wherein cuts in government spending and an increase in taxes leads to the withdrawal of the same piece as the fiscal stimulus measure from the economy. For example, this situation was likely to occur in the U.S in 2013 due to a $500 billion increase in taxes, and a cut in government spending worth $200 posed a threat of pushing the U.S. economy into a severe recession. 

A fiscal cliff situation thus represents a more severe form of fiscal drag that can throw an economy into a prolonged recession and severely drop its GDP. Further, a fiscal cliff may lead to high unemployment due to reduced government subsidies and welfare spending. Additionally, a fiscal cliff situation in the U.S. could increase volatility in the global financial markets.

This article is a guide to What is Fiscal Drag. Here, we explain it with examples and compare it with the fiscal cliff. You can also go through our recommended articles on corporate finance –

• Fiscal Deficit
• Government Spending
• Boom and Bust Cycles