EFA (31): Fiscal drag

In our Economics for Amateurs series, which you can find here each Monday, we recently looked at fiscal policy — that is, the decisions governments take about the levels of taxation and government spending. You can find the previous two posts on fiscal policy here and here.

Today, we look at the concept of fiscal drag. This occurs whenever the government fails to increase tax allowances and bands (or brackets) to take account of rising prices and wages. The result is that an increasing share of gross domestic product goes to the government in taxes.

Let's take a simple example. Imagine that people don't have to pay any tax on the first €10,000 of their earnings (a tax allowance), but then pay a marginal tax rate of 15 per cent tax on the next €10,000 (a tax band) and a marginal rate of 30 per cent of the next €10,000 (another tax band).

If there is no change in the level of wages and prices, the real value of the tax allowance and tax band will stay the same over time.

But wage and price inflation are unlikely to be zero. This means that the nominal levels of the tax allowance and tax band should be increased each year if their real level is to stay the same.

For example, if wage and price inflation are both 10 per cent, the tax allowance and bands would also have to be increased by 10 per cent. This would mean that nobody paid tax on the first €11,000 of their earnings, and then paid 15 per cent on the next €11,000 and so on.

In practice, governments often fail to "index" tax allowances and bands in this way. This allows them to raise more money through taxation in real terms without politically unpopular increases in the basic tax rates.

Governments also often present increases in tax allowances and bands as tax cuts when, in reality, they are simply keeping the real tax burden at the same level.

One of the consequences of fiscal drag is that, over time, people pay a higher percentage of their incomes in taxes even without a real increase in incomes. Indeed, "real fiscal drag" will occur even when the tax bands are increased in line with price inflation if, at the same time, wages rise even faster.

In some cases, fiscal drag actually pushes people into higher tax bands, a process known as "bracket creep".