This sort of effect can be masked by inflation and fiscal drag itself can be used by governments to tweak how much tax certain earners pay.
Given so many of us earn, it’s a good idea to understand this key concept.
How much after tax?
As we’ve seen, a pay rise can push earners into a higher tax bracket, in which they need to pay a higher rate on earnings above a set amount. As a result, their after-tax income might not be as high as they were expecting – after all the earner needs to calculate the effect of the higher tax take on their take home pay.
Consider a tax system in which the income tax rate is 20% up to €20,000 a year, then jumps to 40% for money earned over that limit.
If an earner on €19,500 got a 3% pay rise taking them to €20,085, under our example they will pay tax at 20% for the first €20,000 (€4,000 tax) and 40% on the next €85(€34 tax), making a total of €4034. If they were taxed at 20% for the full amount, the tax paid would only be €4,017. The tax has increased by €17 because of fiscal drag.
This is what economist Friedrich Heinemann called “nominal fiscal drag” (as opposed to inflation adjusted “real fiscal drag”) in his paper After the death of inflation: will fiscal drag survive?.
Dragged up by inflation
Winning a substantial pay rise is not the only way earners become hit by fiscal drag.
Another example is when wages go up by the rate of inflation but tax brackets remain unchanged for long periods. In this situation, earners are eventually dragged up to the higher tax rates – even if the rising cost of living means they have not necessarily become financially better off in real terms.
Boosting government coffers
Moreover, politicians will often adjust tax brackets in a bid to tweak how much tax certain earners pay. So, for example, the government may drop the limit on how much workers earn before they pay a higher rate, meaning they will experience some fiscal drag. (Or, if they raise the limit, some earners may gain).
In technical terms, this is called financial repression.
Following the global financial crisis, government finances in many parts of the world have been strained and the case has been strong to increase their tax revenues.
If I could earn €50,000, I’d be “rich”
A concept known as “money illusion” also comes into play.
Money illusion is the tendency for people to think of the face value of money rather than money’s actual worth – how much it can actually buy.
If earners take a large pay rise at face value, without factoring in the extra tax, they could well be falling for this thinking trap.
No hiding place
Given that, as they say, the only certainties in life are “death and taxes”, fiscal drag is a reality for many.
As a result of fiscal drag, pay increases may not be as large as workers were expecting – or a shift in government tax may see people pay more in tax even when their income stays the same. So, it can pay to stay alert to try to be aware of this potential trap.