Definition of Fiscal Drag
Fiscal drag is a concept where inflation and earnings growth may push more tax payers into higher tax brackets. Therefore fiscal drag has the effect of raising government tax revenue without explicitly raising tax rates.
This fiscal drag has the effect of reducing Aggregate Demand and becomes an example of deflationary fiscal policy. It could also be viewed as an automatic fiscal stabiliser because higher earnings growth will lead to higher tax and therefore moderate inflationary pressure in the economy.
Bracket Creep and Fiscal Drag
If the higher tax rate band is 40% for income over £30,000. Then rising earnings, will mean a higher % of the working population will end up paying the higher rate of income tax.
Fiscal drag could work in the opposite direction. If there is deflation and falling wages, less workers would be in the higher tax bracket. However, deflation has not been common since pre 1939.
Fiscal Drag could be overcome by indexing tax bands to earnings or inflation. However, this is not usually done.
Real Fiscal Drag. If tax brackets are increased in line with inflation, earnings may be growing faster. This means a higher % of earnings will fall in higher tax brackets.
Stamp Duty and Fiscal Drag
In 1993, Stamp Duty was 1% for homes less than £60,000. In 1993, the average house price was £65,000 so many didn’t have to pay stamp duty. By 2005, the average house price had risen to over £150,000, meaning very few no longer paid stamp duty.
In this period, it was estimated the income from stamp duty rose ninefold.