What Is Fiscal Drag?

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DEFINITION
Fiscal drag occurs within an economy where rising inflation and growth in earnings force consumers into higher tax brackets. This creates a situation where consumers pay more taxes and have less purchasing power, even when earning more.

Fiscal drag occurs within an economy where rising inflation and growth in earnings force consumers into higher tax brackets. This creates a situation where consumers pay more taxes and have less purchasing power, even when earning more.

Fiscal drag affects you as an earner and consumer. It’s important to understand what it is, how it works, and what a government can do to keep it under control.

Definition and Examples of Fiscal Drag

The term “fiscal drag” refers to an economic situation where rising inflation decreases the purchasing power of a currency while earnings are growing simultaneously.

  • Alternate definition: The difference between actual GDP and potential GDP. Potential GDP is what an economy could produce when it fully employs all its resources.

During economic upswings, a government should adjust the tax brackets to reflect earnings growth and inflation; if it doesn’t, the economy will experience drag because the government is essentially increasing tax revenues and taking away from the country’s gross domestic product (GDP).

If fiscal policy is not implemented during rising inflation and earnings growth, the economy experiences fiscal drag—the combination of economic drag and no fiscal policy response from a government. This tends to occur after economic downturns or recession troughs, and reverse because governments tend to increase spending to stimulate the economy during the downswing.

Fiscal policy refers to spending and tax decisions made by a government. It can increase or decrease taxes and spending to stimulate or restrict an economy’s growth.

For example, following the 2008-2010 financial crisis, temporary Social Security payroll tax cuts expired along with new taxes associated with President Obama’s health care legislation. During the economic recovery period in 2012-2013, wages were increasing, and inflation rose. This created fiscal drag in the economy because consumers had less money to spend or more taxes to pay.

How Does Fiscal Drag Work?

Fiscal policy can either be expansionary or contractionary. Expansionary policy is an increase in government spending and a decrease in taxes; contractionary policy decreases government spending and increases taxes. Governments use expansionary fiscal policy during contractions and contractionary policy during expansions. The countercyclical actions taken by governments are designed to slow and control economic growth and shrinkage.

Because fiscal policy is countercyclical in nature, the federal deficit tends to fall during economic expansions or recovery periods. Consumers might be spending less because they are paying more taxes, and the government might be spending less because economic stimulus measures are being scaled back.

Fiscal drag occurs naturally following periods of expansionary fiscal policy because governments wait for official announcements or indications that a recession or depression is over. The indicators and announcements generally lag behind the beginning of the recovery, so it is normal to have a period where wages and inflation increase before the government implements tax and spending changes.

An increase in taxes can also cause fiscal drag.

For example, say an economy experienced a recession. Tax revenues declined because more people were laid off or otherwise lost their jobs. At the same time, local and state governments experienced an increase in unemployment insurance and Medicaid expenditures because they are automatic programs people qualify for during economic downturns. Because the local and state governments needed to balance their budgets, they had to reduce spending during the recession or increase taxes.

When recovery begins, people slowly get back to work, earnings go up, and tax revenues increase. However, governments don’t react until they are confident the recession is over, so fiscal drag is induced.

Is the U.S. Experiencing Fiscal Drag?

Fiscal drag tends to follow periods of financial support, such as when stimulus checks are distributed by the government. When fiscal support is the largest—as a percentage of GDP—the years following this support tend to have the highest level of fiscal drag.

Due to the significant financial support provided by the federal government in 2020 and 2021, there is a significant fiscal drag projected through 2030, according to the White House Council of Economic Advisers. The group has data that shows what fiscal support and drag have looked like in the U.S. economy since 1940. For 2022, the predicted fiscal drag is 9% of GDP, the largest since World War II.

Key Takeaways

  • Fiscal drag refers to an economic situation where inflation and earnings grow and force earners to have less purchasing power and money to spend, while also paying more taxes.
  • Fiscal drag can be measured as the difference in actual GDP and potential GDP.
  • The countercyclical nature of fiscal policy means that periods of fiscal drag tend to occur after periods of fiscal support.

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