What is the budgetary brake?
The fiscal brake is an economic term by which inflation or income growth pushes taxpayers into higher tax brackets. This actually increases government tax revenue without actually increasing tax rates. Raising taxes reduces aggregate demand and consumer spending by taxpayers, as more of their income is now spent on taxes, leading to deflationary policies or dragging down the economy.
Key points to remember
- The fiscal slowdown is the result of a decrease in consumer spending resulting from an increase in taxation which eventually reduces aggregate demand, leading to deflationary pressures.
- Progressive taxation, whereby individuals are moved to higher tax brackets due to inflation or increased income, is a fiscal policy that results in a fiscal drag.
- Progressive taxation makes it possible to increase government taxation without actually increasing taxes.
- The fiscal slowdown can be seen as an automatic fiscal stabilizer, as it prevents a rapidly expanding economy from overheating.
Understanding the budget brake
Fiscal slowdown is essentially a slowdown in the growth of the economy caused by a lack of spending as increases Taxation slows the demand for goods and services. When an economy is expanding rapidly, inflation results in higher incomes and as a result, individuals move to higher tax brackets and pay more of their income in taxes. This is particularly the case in economies where progressive taxesor tax brackets, which state that the higher an income, the higher the tax it pays and thus moves into a higher tax bracket.
Moving to a higher tax bracket and paying more income in taxes, as mentioned earlier, leads to an eventual slowdown in the economy because there is now less income available for discretionary spending.
It is common to regard the fiscal slowdown as a natural economic stabilizer, as it tends to keep demand stable and prevent the economy from overheating. This is generally seen as moderate deflationary policy and a positive aspect of the fiscal slowdown.
Example of a budgetary constraint
John is a mechanic who made $50,000 three years ago. In John’s country, he is not taxed on the first $15,000 of his income. He is therefore taxed on $35,000 at the rate of 20%, or $7,000. In this scenario, John paid 14% of his income in taxes. $7,000 divided by $50,000.
Today, John earns $65,000 and the additional $15,000 of his income is taxed at a rate of 35%. John’s total tax cost is now $12,250, or 18.8% of his annual income, an increase from the previous 14% and a larger portion of his total income.
In John’s economy, the prices of most goods have risen at the same rate as his salary over the past three years. More of his income will now have to be used to pay for basic goods and he will have less income for discretionary spending. This will result in a drag on the economy if the same scenario were to be amplified across the population of John’s country.