Fiscal Drag: How It Impacts Taxes and Government Revenue

As wages and prices rise over time, individuals may find themselves paying a higher percentage of their income in taxes even if their purchasing power hasn’t improved. This phenomenon, known as fiscal drag, increases tax burdens while boosting government revenue without explicit tax rate hikes. It results from inflation, income growth, and a tax system that doesn’t automatically adjust for these factors.

Progressive Tax Rates

Many tax systems use progressive rates, meaning higher incomes are taxed at higher percentages. However, when wages rise due to inflation, taxpayers may move into higher brackets without a real increase in purchasing power.

For example, in the United States, the federal income tax system has multiple brackets, with rates ranging from 10% to 37% as of 2024. If a taxpayer’s salary increases from $95,000 to $105,000, they may move from the 22% bracket into the 24% bracket. While only the income above the threshold is taxed at the higher rate, their overall tax burden still rises. This effect is more pronounced in countries where tax brackets are not regularly adjusted for inflation.

Some governments address this issue by indexing tax brackets to inflation. The U.S. tax code adjusts brackets annually based on the Consumer Price Index (CPI), but not all jurisdictions follow this practice, which can erode disposable income over time.

Tax Threshold Structures

Many tax systems include income thresholds that determine eligibility for deductions, credits, or additional taxes. When these thresholds remain fixed while wages rise, more taxpayers lose benefits or face higher taxes despite no real improvement in their financial situation.

For example, the Additional Medicare Tax in the U.S. applies a 0.9% surtax on wages exceeding $200,000 for single filers and $250,000 for married couples filing jointly. These thresholds have remained unchanged since the tax was introduced in 2013, meaning more workers become subject to the tax as salaries grow.

Similarly, the income limit for contributing to a Roth IRA phases out between $146,000 and $161,000 for single filers in 2024. If these limits do not rise with inflation, individuals who previously qualified may lose the ability to contribute, restricting their retirement savings options.

Tax credits are also affected. The Child Tax Credit begins to phase out at $200,000 for single filers and $400,000 for joint filers. Without adjustments, families earning slightly more over time may lose access to these benefits, increasing their tax burden. This is particularly significant for middle-income households that rely on such credits to offset living costs.

Unindexed Deductions and Exemptions

Tax deductions and exemptions reduce taxable income, lowering the amount owed. However, when these amounts remain fixed while wages and costs rise, their real value declines, leading to higher tax liabilities.

For instance, the standard deduction in the U.S. tax code is adjusted annually for inflation, but many itemized deductions are not. The state and local tax (SALT) deduction, capped at $10,000 since the Tax Cuts and Jobs Act (TCJA) of 2017, has not increased despite rising property taxes and state levies. As housing costs climb, more taxpayers find themselves unable to deduct their full expenses, increasing their taxable income.

Business-related deductions can also be affected. The Section 179 expense deduction, which allows businesses to deduct the cost of equipment purchases, has statutory caps that may not fully keep pace with inflation. If a small business owner previously deducted the full cost of a $1 million piece of machinery but inflation pushes that same equipment to $1.2 million, they could face a higher tax bill due to the deduction limit remaining unchanged. This can discourage investment and strain cash flow, particularly for smaller enterprises.

Real Income Growth

Wage increases are expected to improve financial well-being, but when tax policies do not account for inflation, even modest raises can lead to higher tax rates, reducing the benefit of nominal income growth.

Employers also face fiscal drag through payroll taxes. Many payroll tax obligations, such as Social Security and unemployment insurance, are based on income thresholds that may not adjust annually. Without inflation-indexed caps, businesses could see rising payroll tax expenses, influencing hiring decisions and labor costs.

Fiscal drag gradually shifts more income into higher tax brackets and reduces the value of deductions and credits, increasing tax burdens without explicit rate hikes. While some governments adjust tax policies to account for inflation, many thresholds remain static, leading to a slow but steady increase in tax liabilities over time.