Fiscal drag as a cost of inflation

In my ECONS101 class, we cover the costs of inflation (albeit in the part of the paper taught by Les Oxley). One of the costs of inflation is 'tax distortions', which arises from 'bracket creep'. Apparently, bracket creep can also be referred to as 'fiscal drag'. At least, that is how it is referred to in this recent article in The Conversation, by Jonathan Barrett (Victoria University of Wellington). Barrett explains that:

New Zealand’s income tax system uses progressive rates. Higher slices of income are taxed at higher rates. Every dollar earned up to NZ$14,000 is taxed at 10.5%. Income above that level is progressively taxed higher until the final tax rate of 39% applies to every dollar earned over $180,000.

“Fiscal drag”, sometimes known as “bracket creep”, occurs when an increase in a taxpayer’s income takes their highest slice of income into a higher tax bracket without an increase in real income. This often happens when wages rise to compensate for inflation but tax bands are not adjusted.

Since it is marginal tax rates that matter for incentives, shifting taxpayers into tax brackets with higher marginal tax rates may change their behaviour, without changing their underlying real income. For example, taxpayers may choose to work more (or work less) as a result of moving into a higher tax bracket, than they would have if the brackets had adjusted along with their incomes (and wage inflation), leaving them in the same tax bracket as before. That creates unnecessary distortions in taxpayers' labour market behaviour.

Aside from lower inflation (which would decrease all of the various costs associated with inflation), the solution to fiscal drag is to adjust tax brackets for inflation, otherwise known as 'indexing'. However, it is difficult to get any taxpayer excited about the prospect of indexing tax thresholds. As Barrett notes:

Why do many employees not seem to care about fiscal drag? Perhaps it’s because, psychologically, it doesn’t feel the same as an overt tax increase. Even if the real value of your pay decreases, the amount you take home is stable.

Conversely, index linking may not feel like a tax cut. People understand that prices are rising but they may not necessarily link inflation to their tax levels.

So, unlike some of the other costs of inflation, such as menu costs and shoe leather costs, the costs of tax distortions are a bit less visible to people. In fact, these costs will be almost totally invisible to those who don't change tax brackets. That makes it difficult to convince taxpayers that policy action is necessary. Nevertheless, this is something that warrants greater attention, given that the median weekly earnings of $1189 (for wage and salary earners) is already fairly close to the $70,000 threshold ($1346 weekly) for the 33 percent marginal tax rate. It won't be too long before more than half of salary and wage earners are in that tax bracket, which would seem unnecessary given that their real incomes are not rising.