Chapter 7: Problem 221

What does the expression 'fiscal drag,' popular in the \(1960^{\prime} \mathrm{s}\), mean?

Short Answer

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Fiscal drag refers to the negative effect of progressive taxation on economic growth, causing individuals and businesses to alter their behavior to avoid higher tax rates. In the 1960s, higher-income groups faced high marginal tax rates, leading to a decrease in economic growth as they had less incentive to work or invest. Remedies for fiscal drag include adjusting tax policies, such as reducing tax rates for higher-income groups or implementing a flat tax system, and adjusting tax brackets for inflation.

Step by step solution

Definition of Fiscal Drag

The term "fiscal drag" refers to the negative effect of progressive taxation on economic growth. It occurs when an increase in income leads to a higher percentage of that income being taxed.

Progressive Taxation

Progressive taxation is a tax system in which the tax rate increases as the taxable amount increases. So, the more a person earns, the higher the percentage of their income they will be taxed.

Fiscal Drag in the 1960s

In the 1960s, the term 'fiscal drag' became popular as higher-income groups faced high marginal tax rates with progressive taxation. This led to a decrease in economic growth, as high-income earners had less incentive to work or invest due to the increasing amount of their income taken away as tax.

Effects of Fiscal Drag

Fiscal drag can lead to inefficiencies in the economy, as individuals and businesses may alter their behavior to avoid higher tax rates. For instance, high-income individuals may reduce their working hours or avoid productive investments, as the higher tax burden discourages them from generating more income.

Remedies for Fiscal Drag

To reduce the negative impact of fiscal drag on the economy, governments can adjust their tax policies, such as reducing tax rates for higher-income groups or implementing a flat tax system. In addition, adjusting tax brackets for inflation can also help to limit fiscal drag, as it ensures that increasing incomes do not automatically lead to higher tax burdens due to inflation.