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CA Foundation · Business Economics · Public Finance

An economy experiences fiscal drag when nominal incomes rise but tax brackets remain unchanged, pushing taxpayers into higher brackets despite unchanged real purchasing power. In inflationary times, which approach best counteracts fiscal drag?

Indexing tax brackets to inflation prevents fiscal drag by automatically adjusting nominal bracket thresholds upward with price levels, ensuring rising nominal incomes don't artificially increase real tax burdens when purchasing power remains constant.

  1. AReducing overall tax rates uniformly across all income brackets
  2. BIndexing tax brackets annually to inflation to maintain constant real tax burdenCorrect
  3. CIncreasing government spending proportionally to increased tax collection
  4. DIntroducing new, higher tax brackets without adjusting existing ones

Explanation

Indexing tax brackets to inflation maintains the real tax burden unchanged by adjusting nominal bracket thresholds upward as prices rise. This prevents nominal income growth from unintentionally increasing real tax rates. Uniform rate reduction does not address bracket creep; increased spending does not solve the problem; and new brackets worsen it. Indexation directly counters fiscal drag's core mechanism.

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