Real growth and fiscal drag

Given the statutory structure of the personal income tax of a country, the average tax rate (i.e., the ratio of total income tax revenue to gross income) will increase whenever the country's income at current prices rises. It will not matter whether the increase in income is due to price changes, to real growth, or to both. The percentage increase in the average tax rate over a given period of time will depend on the rate of growth of current income and on the elasticity of the tax. The absolute increase, however, will depend also on the tax rate itself. The higher the tax rate at a given moment, the greater the absolute increase in the rate brought about by a given percentage change in income (given the elasticity).

The automatic increase in revenue brought about by increases in current income is often referred to as “fiscal drag” or “fiscal dividend.” The fiscal drag can be labeled an inflationary (or monetary) fiscal drag or a real fiscal drag, depending on whether it is brought about by income changes that reflect inflation or real growth. Indexation for price changes, as discussed in Chapters 2 and 3, will remove the inflationary fiscal drag but not the real fiscal drag. Therefore, if real growth is fast, the elasticity of the tax is high, and the average tax rate is substantial, the absolute increase in the tax rate brought about by real fiscal drag can be significant.