Fiscal Drag

Definition

The effect by which inflation or rising nominal incomes push taxpayers into higher tax slabs even though their real income has not risen, so the government's tax take rises and demand is dragged down.

Key points

• It happens when tax slabs (the income thresholds) are not adjusted ("indexed") for inflation; rising money incomes cross fixed thresholds.
• This is also called "bracket creep": people pay a higher average rate of tax without any real gain in living standards.
• It acts as an unlegislated tax increase and an automatic brake on demand, so it behaves like an automatic stabiliser; see concept automatic stabilisers.
• Governments can offset it by raising or indexing the slabs to inflation in the annual budget.
• It links to the distinction between concept real vs nominal interest and to real versus nominal income more broadly.

Why it matters for CAPF

The definition (inflation pushing people into higher tax brackets, raising real tax burden) and the term "bracket creep" are testable fiscal terms.

Common confusion

Fiscal drag (inflation pushing taxpayers into higher slabs and raising tax take) is sometimes confused with crowding out; fiscal drag is about taxation and bracket creep, not government borrowing.

Parent note

budget and fiscal policy