Fiscal drag takes place when the government’s fiscal position is incompatible with the position of the private sector in terms of savings. During times of fiscal drag, individuals have to allocate a higher percentage of their salaries to taxes.
Fiscal drag usually occurs as a result of too much taxation. It also comes about as a result of less spending on the part of the government.
A variety of factors bring about fiscal drag, one of these being bracket creep. In fact, these two terms are often taken interchangeably because of such close association with each other.
Bracket creep takes place when enough inflation occurs to cause adjustments in tax brackets. People are moved to higher tax brackets.
When inflation takes place, salaries are increased, but the actual value and spending power of the wage earner does not improve. Since progressive taxation imposes higher taxes on those who earn more, then those whose salaries have increased are required to pay higher taxes, as well.
As a result of the increase in tax impositions on wage-earners, spending power goes down. This then translates into a decreased demand for products and services. This can actually serve to stabilize the economy in a natural manner, as it ensures that demand for goods and services remains stable.
