The Central Bank of Latvia published Working Paper 7/2025 analysing “fiscal drag”, where tax revenues rise as nominal incomes increase while progressive tax parameters are not adjusted. Using a microsimulation approach, the paper characterises fiscal drag across 21 European countries and links theoretical sensitivity measures to the realised effects observed in recent years. The study estimates tax-to-base elasticities and finds that progressivity in many personal income tax systems implies elasticities of around 1.7–2, suggesting scope for sizeable fiscal drag. It decomposes these elasticities by mechanism (tax brackets versus deductions, credits and allowances), by income source (labour, capital, self-employment and public benefits), and across the income distribution. The analysis then evaluates fiscal drag in practice between 2019 and 2023 by combining observed income growth with legislative changes, quantifying the impact and the extent to which indexation or other reforms offset it.
Central Bank of Latvia 2025-10-14
Central Bank of Latvia working paper measures fiscal drag potential and 2019–2023 outcomes across 21 European countries
The Central Bank of Latvia released Working Paper 7/2025, examining "fiscal drag" in 21 European countries using a microsimulation approach. The study finds tax-to-base elasticities of 1.7–2 in many personal income tax systems, indicating potential for significant fiscal drag. It evaluates fiscal drag from 2019 to 2023, considering income growth and legislative changes, and assesses the impact of indexation and reforms.