In the case of fiscal drag, an upturn in GDP during a growth period is likely to be accompanied by a rise in real incomes. However, progressive taxes and welfare benefits provide a limiting influence on this rise.
This arises for two reasons – firstly, in the theoretical absence of welfare benefits and progressive taxes, a boost to economic growth is likely to reduce unemployment, leading to a significant rise in average incomes as the unemployed (existing without benefits) now move into paid work. However, with welfare benefits in place, the fall in unemployment would result in a more modest increase in personal incomes as individuals move from living on benefits to living on wages from employment. Hence the ‘boost’ to incomes from economic growth is constrained.
Secondly, with progressive taxes and in a period of economic growth, individuals and firms will pay more tax, and hence retain less of their income than if the taxes were not progressive. Furthermore, some individuals may jump into a higher tax band (say from 20% to 40%) again retaining less income from which to spend.
The net result is that any rise in income and the consequential upward multiplier effect, would be less extreme.
Graphically, the upturn will not be as steep when fiscal drag is taken into account.
More on fiscal drag
The combined effect of fiscal boost and drag is to automatically stabilise the macro-economy following an economic shock.