fiscal drag, bracket creep

Wikipedia: fiscal drag

Fiscal drag refers to the process where tax thresholds are either not adjusted for inflation, or fail to keep pace with earnings growth, causing in either case an automatic rise in tax revenues.

Example of nominal fiscal drag

Suppose a person earns $20,000 per year and is liable to 20% tax on earnings above a threshold of $5,000 per year. Then they pay (20000-5000)*0.2 = $3000 in tax, or 15% of income. Now suppose that due to inflation, their wage goes up by 5%, but the government only increases the tax threshold by 2%. They must now pay (21000-5100)*0.2 = $3180 or 15.14%. The proportion of income as tax has increased - this is fiscal drag.

Bracket creep

Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets. Many progressive tax systems are not adjusted for inflation. As wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate.

Real fiscal drag

Real fiscal drag takes place when tax thresholds are increased in line with price rises to avoid nominal fiscal drag, but where a growing economy means that earnings rise faster still, so increasing taxes as proportion of earnings.

bracket creep: Definition from Answers.com