Fiscal drag happens when the government's net fiscal position (spending minus taxation) fails to cover the net savings desires of the private economy, also called the private economy's spending gap (earnings minus spending and private investment). The resulting lack of aggregate demand leads to deflationary pressure, or drag, on the economy, essentially due to lack of state spending or to excess taxation.
One cause of fiscal drag may be bracket creep, where progressive taxation increases automatically as taxpayers move into higher tax brackets due to inflation. This tends to moderate inflation, and can be characterized as an automatic stabilizer to the economy. Fiscal drag can also be a result of a hawkish stance towards government finances.
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Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets.
Many progressive tax systems are not adjusted for inflation. As wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate.
Suppose a person earns $20,000 per year and is liable to 20% tax on earnings above a threshold of $5,000 per year. Then they pay (20000-5000)*0.2 = $3000 in tax, or 15% of income. Now suppose that due to inflation, their wage goes up by 5%, but the government only increases the tax threshold by 2%. They must now pay (21000-5100)*0.2 = $3180 or 15.14%. The proportion of income as tax has increased - this is fiscal drag.
The US Federal surplus of the late Clinton years is an example of fiscal drag from declining spending in relation to taxes. During this time, large balance of payment deficits and private savings desires were not offset by government deficits, leading to insufficient demand in relation to economic production, slower economic growth, and lingering unemployment- i.e. the 90's boom came to an end.[1]
Real fiscal drag takes place when tax thresholds are increased in line with price rises to avoid nominal fiscal drag, but where a growing economy means that earnings rise faster still, so increasing taxes as proportion of earnings.
Though nominal bracket creep can easily be countered by a system of index-linked tax brackets, this may be politically undesirable. Many voters do not perceive the effects of bracket creep, and so the government may prefer to adjust tax brackets manually once every few years - in effect restoring the real tax rates to their approximate pre-inflation levels, but in a way that gives the government the appearance that they are cutting taxes. Not surprisingly, such changes are usually made right before a general election is to be held.
Ireland is an example of a country in which, in recent years, the progressive income tax system has allowed government revenues to swell due to both nominal and real fiscal drag without either increases in the tax rates or decreases in the thresholds. This is because the country has experienced considerable economic growth, which some attribute to the low-interest monetary regime of the European Central Bank, resulting in high wage inflation. Whereas others attribute to the economic and educational policies of the Irish government, in subsidizing education and eliminating taxation of the arts, two historically low-income demographics who would thus respond strongly to an increase in income, resulting in price inflation and thus wage inflation to retain Purchasing power parity.
Taxing Wages 2006/2007: 2007 Edition, OECD.