Fiscal drag is an economics term referring to a situation where a government’s net fiscal position (equal to its spending less any taxation) does not meet the net savings goals of the private economy. This can result in deflationary pressure attributed to either lack of state spending or to excess taxation.
One cause of fiscal drag is the consequence of expanding economies with progressive taxation. In general, individuals are forced into higher tax brackets as their income rises. A greater tax burden can lead to less consumer spending. For the individuals pushed into a higher tax bracket, the proportion of income as tax has increased, resulting in fiscal drag.
Fiscal drag is the tendency of revenue from taxation to rise as a share of GDP in a growing economy. Tax allowances, progressive tax rates and the threshold above which a particular rate of tax applies usually remain constant or are changed only gradually. By contrast, when the economy grows, income, spending and corporate profits rise. So the tax-take increases too, without any need for government action. This helps to moderate the rate of increase in demand, reducing the pace of growth, making it less likely to result in higher inflation. Thus fiscal drag is an automatic stabiliser, as it acts naturally to keep demand stable.
