Fiscal drag in theory and in practice: A European perspective

This paper presents a comprehensive characterization of “fiscal drag” —the increase in tax revenue that occurs when nominal tax bases grow but nominal parameters of progressive tax legislation are not updated accordingly— across 21 European countries using a microsimulation approach. First, we estimate tax-to-base elasticities, showing that the progressivity built in each country’s personal income tax system induces elasticities around 1.7-2 for many countries, indicating a potential for large fiscal drag effects. We unpack these elasticities to show stark heterogeneity in their underlying mechanisms (tax brackets or tax deductions and credits), across income sources (labor, capital, self-employment and public benefits), and across the individual income distribution. Second, we extend the analysis beyond these elasticities to study fiscal drag in practice between 2019 and 2023, incorporating observed income growth and legislative changes. We quantify the actual impact of fiscal drag and the extent to which government policies have offset it, through either indexation or other reforms. Our results provide new insights into the fiscal and distributional effects of fiscal drag in Europe, as well as useful statistics for modeling public finances.