Income Tax Indexation and Fiscal Drag: Effects on the Personal Tax Burden

This paper studies whether indexation of personal income tax parameters mitigates fiscal drag, focusing on the Average Income Tax Rate (AITR) on labor income. Using an OECD panel, we estimate the impact of the intensity of inflation on the AITR, differentiating by non-indexing and indexing systems. We show that indexation systematically changes the inflation-AITR relationship by weakening the passthrough from inflation into average tax rates. We show that the increase in the Consumer Price Index from 2019 to 2024 is associated with a decrease in the average AITR of more than 1.75 percentage points due to indexing regimes and an increase of 1.18 percentage points due to non-indexing regimes. The differential impact of the indexation of the fiscal system implies a decrease of the inflation impact on AITR of 0.57 percentage points, which is about 3% of the mean of the AITR in 2019. This means that the average income tax, when the fiscal system is indexed to inflation, decreases following an increase in consumer prices: the purchasing power of wages, even when updated, usually declines after inflation, and we show that if the fiscal system is properly indexed, it will take this into account by decreasing taxes.