Explain the concept of fiscal drag.

Fiscal drag refers to a situation where the government's fiscal policy unintentionally reduces aggregate demand and economic growth. It occurs when the government fails to adjust tax brackets and thresholds for inflation, resulting in individuals and businesses being pushed into higher tax brackets as their incomes rise due to inflation.

When tax brackets and thresholds are not adjusted for inflation, individuals and businesses experience a decrease in their real income. As a result, they have less disposable income available for consumption and investment, leading to a decrease in aggregate demand. This decrease in aggregate demand can lead to a slowdown in economic growth or even a recession.

Fiscal drag can also have negative effects on income distribution. As individuals and businesses are pushed into higher tax brackets, they face higher tax rates, which can reduce their incentive to work, save, and invest. This can lead to a decrease in productivity and economic efficiency.

To mitigate fiscal drag, governments need to regularly adjust tax brackets and thresholds for inflation. By doing so, they can ensure that individuals and businesses are not unfairly burdened by higher taxes due to inflation. This adjustment helps to maintain the purchasing power of taxpayers and supports economic growth by preserving aggregate demand.

In summary, fiscal drag is a phenomenon that occurs when the government fails to adjust tax brackets and thresholds for inflation, leading to a decrease in real income, lower aggregate demand, and potential negative effects on income distribution. Regular adjustments to tax brackets and thresholds are necessary to mitigate fiscal drag and support economic growth.