Fiscal drag happens when government’s net fiscal position ( minus taxation) fails to cover the net savings desires of the private economy, it is also called the private economy’s spending gap. The resulting lack of aggregate demand leads to deflationary pressure, or drag, in the economy, essentially due to lack of state spending or to excessive taxation.
One cause of fiscal drag is bracket creep, where progressive taxation increases automatically as taxpayers move into higher tax brackets due to inflation. This leads to moderation of inflation, and can be characterized as an automatic stabilizer of the economy. Fiscal drag can also be a result of a hawkish stance towards government finances.
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Definition of Fiscal Drag
Fiscal drag basically means a slowdown of economic growth due to lack of spending as increased taxation reduces demand for goods and services. During a rapid expansion of the economy inflation results in high income an therefore individuals move to higher tax brackets and ultimately pay more of their income in taxes
This is particularly the case in economies with progressive taxes, or tax brackets, which stipulate that the higher income an individual makes the higher the tax they pay and thus they move into a higher tax bracket.
Moving into a higher tax bracket and paying a larger portion of income in taxes, as mentioned prior, results in an eventual slowing of the economy as there is now less income available for discretionary spending.
It is common to view fiscal drag as a natural economic stabilizer as it tends to keep demand stable and the economy from overheating. This is generally viewed as a mild deflationary policy and a positive aspect to fiscal drag.
Consider the following statements:
- Fiscal drag is also called private economy’s spending gap.
- Bracket Creep is one of the causes of fiscal drag.
Which of the following statements is correct:
a) Only 1.
b) Only 2.
c) Both 1 & 2
d) None of the above
Answer: C
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FAQ about Fiscal Drag
What is fiscal drag and boost?
What does fiscal drag refers to?
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