Background
Fiscal drag refers to the phenomenon where, under progressive tax systems, the proportion of income collected in taxes increases due to inflation. This occurs because the thresholds for income tax payments and for higher tax rate applications are often fixed in nominal terms, not adjusted for inflation.
Historical Context
Fiscal drag becomes particularly significant in periods of high inflation. Historically, this concept has been examined in the context of post-World War II economies experiencing high inflation rates, and potentially during severe economic events like the oil crises of the 1970s, where both inflation and taxation policies became critically interconnected.
Definitions and Concepts
Fiscal Drag
The tendency under progressive tax systems for the proportion of incomes collected in taxes to rise due to inflation, as tax thresholds remain unchanged in money terms.
Specific Taxes
Taxes set on certain goods, services, or transactions that do not adjust automatically with inflation, thus reducing the effective incidence of fiscal drag on these indirect taxes.
Tax Arrears
The situation where tax payments are made after the period in which the income was earned, typically reducing immediate inflationary impacts on fiscal drag.
Major Analytical Frameworks
Classical Economics
Classical economics doesn’t address fiscal drag directly but assumes a more stagnant view of economic variables including taxes.
Neoclassical Economics
This framework likely examines fiscal drag through the lens of household utility maximization, analyzing the decreasing disposable income with rising tax burdens amidst inflation.
Keynesian Economics
Keynesian economists might evaluate fiscal drag in the context of aggregate demand, emphasizing how increased tax burdens can dampen consumer expenditure and economic growth.
Marxian Economics
From a Marxian perspective, fiscal drag could be viewed in terms of class exploitation, examining how fixed tax thresholds exacerbate income inequalities in inflationary periods.
Institutional Economics
Institutionalists would look at the policies and rules governing tax thresholds, exploring why these might not adjust under inflationary conditions and how this pertains to institutional rigidity.
Behavioral Economics
Behavioral economists might be interested in how people perceive and react to fiscal drag, analyzing differences in taxpayer behavior as their tax burdens increase in real terms.
Post-Keynesian Economics
Post-Keynesian analysis could focus on how fiscal drag affects income distribution and the functioning of fiscal policy in stabilizing the economy.
Austrian Economics
Austrian economists might critique fiscal drag by emphasizing the distorting effects of inflationary policies and calling for more dynamic adjustments to tax systems.
Development Economics
In developing economies, the issue of fiscal drag could be profoundly significant, where stable and fair tax policies are essential to economic stability and growth.
Monetarism
Monetarists would likely relate fiscal drag to inflation’s broader economic impacts, advocating for price stability and potentially income-adjusted tax thresholds.
Comparative Analysis
Fiscal drag can be more pronounced in economies with steeply progressive tax systems and high inflation rates, whereas it might be less significant in flat tax systems or where inflation is low. Comparisons between countries or periods can show how effectively different economic systems and policies mitigate fiscal drag.
Case Studies
Examining countries like the UK during the 1970s or Argentina in modern times can yield deep insights into how fiscal drag impacts economies steeped in inflation.
Suggested Books for Further Studies
- “Fiscal Policy and Business Cycles” by Alvin H. Hansen
- “Macroeconomics” by Olivier Blanchard
- “Tax Systems and Tax Reforms in South and East Asia” edited by John Gillingham
- “Public Finance and the Price System” by Edgar K. Browning and Jacqueline M. Browning
Related Terms with Definitions
- Progressive Taxation: A taxation system where the tax rate increases as taxable income increases.
- Deflationary Spiral: A situation where decreased spending leads to a decrease in production, leading to lower wages and demand, further controlling prices downward.
- Bracket Creep: The process by which inflation pushes taxpayers into higher income tax brackets.
- Tax Indexation: Adjusting tax brackets and thresholds according to inflation to counteract the effects of fiscal drag.
