fiscal drag

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Fiscal Drag

Reduced activity in an economy as a result of a progressive tax system set up in such a way as to penalize extra earnings. For example, suppose a gross income more than $50,000 per year increases one's tax liability such that a person effectively earns less than he/she would have at $45,000 gross. A rational economic actor would therefore endeavor to lower his/her gross income. This in turn lowers spending and reduces the supply of money in an economy available to purchase goods and services. The diminished activity is called fiscal drag.

fiscal drag

the restraining effect of PROGRESSIVE TAXATION on economic expansion. As NATIONAL INCOME rises, people move from lower to higher tax brackets, thereby increasing government TAXATION receipts. The increase in taxation constitutes a ‘leakage’ (from the CIRCULAR FLOW OF NATIONAL INCOME) that will reduce the rate of expansion of AGGREGATE DEMAND below that which would otherwise be the case. Governments may choose as part of FISCAL POLICY to adjust for the effects of fiscal drag by regularly increasing personal tax allowances.

Fiscal drag can also serve to automatically constrain the effect of the pressure of INFLATION in the economy, for with a high rate of inflation people will tend to move into higher tax brackets, thereby increasing their total taxation payments, decreasing their disposal income and reducing aggregate demand. This has the effect of reducing the pressure of DEMAND-PULL INFLATION. See AUTOMATIC ( BUILT-IN) STABILIZERS.