Fiscal Drag - An Automatic Stabiliser?

Inflation can alter the structure of tax systems and lead to higher real tax burdens. The ‘automatic stabiliser’ argument assumes that increasing tax burdens reduce consumption and thereby aggregate demand, acting as an automatic stabiliser which helps to ‘cool down’ the economy in times of inflation. This argument, however, only looks at the demand side, ignoring any effects that higher tax burdens may have on the cost of production. If employees bear less then the full burden of higher taxes then real labour costs will also go up, generating a cost-push upwards pressure on prices and opening up the possibility of a wage-price spiral. I compute distributions of inflation induced changes of marginal and average effective tax rates for four European countries using a preliminary version of EUROMOD, a European tax-benefit model. Possible wage effects of these changes are then discussed in an imperfect labour market framework.