Fiscal Drag – 8 Mark A-Level Economics Question (Edexcel)

Added: 2026-05-15

[00:00:00]So, eight more question. With reference to figure four, again an extract A, examine the likely impact of the freeze in income tax thresholds on aggregate demand. Now, and a great question and it just makes me smile this question does since how embedded it is in a real-world application. So, I mentioned it in the previous question, but for those of you who don't know, the freeze in income tax thresholds is of course referring to the concept of fiscal drag. Now, that is of course bedded embedded in real-world application, but it's really funny since it reminds me of last year where which is the year we sat this paper, I did a live class specifically on the concept of fiscal drag since it was very popular in the news and it's just a very good bits of bit of real-world application.

[00:00:41]And I had a lot of students asking me, "Why are we learning about this? It is not in the spec." But, this is the thing with Edexcel and since it links so much to the spec, yes, it's not explicitly stated in the spec, but it's some real-world it's some good really good real-world application they can back your points up with. And in that exact year, it came up in the exam paper and since they knew about it, they could score so much better on this question rather than if it was the first time you looking at it. Now, I understand I'm always emphasizing real-world application, but it pays absolute dividends. If you understand the macroeconomy, you know your examples for the globalization section, if you know your countries for micro, if you know your industries, I've been through so many A-star students now and it's just what is needed for that A-star, that top level.

[00:01:23]It just shows the examiner that depth of knowledge and that appreciation of the real world, not just the theory of economics, the real-world application of that theory. And it's those two things combined which makes that A-star student. Whereas on the opposite side of the spectrum, if you don't know what fiscal drag is, it's going to take you a hell of a lot of time to understand what they actually mean by freezing the income tax bands. You got to read the extract, fully internalize what that means and that will just take time and time. Now, in this paper, there were students who saw the freeze in income tax thresholds, didn't know what fiscal drag was, and thought the question was asking them or telling them that they're going to completely get rid almost of income tax thresholds for a short period of time, which is totally unreasonable.

[00:02:01]Of course, would not happen, but if they answer like that, of course, they cannot pick up any marks. And again, it shows the importance of that real-world application. But let's go on to explaining what actually what actually this concept of freezing the income tax thresholds actually does. So, fiscal drag occurs when the government freeze income tax bands. That has been done right now by the government where they are frozen till 2029. This means that income tax bands do not rise in line with inflation. So, more individuals are dragged into higher income tax bands, which is why we call it fiscal drag.

[00:02:32]They're dragged into higher income tax bands, even though realistically, in real terms, in purchasing power terms, their income hasn't increased or maybe has decreased. So, to make sure you never forget this concept, let me explain this really simply. So, in 2022, if you have a salary of £48,000, but then in 2023, as you know, there's high levels of inflation. So, due to inflation, if your wage rises, and for example, if your wage now rises by £4,000. So, in 2022, you were earning £48,000, and in 2023 now, you are earning £52,000. Now, the main thing to remember, your wage has risen in line with inflation. You are not, in real terms, actually making more money since goods and services are just more expensive now. So, to get the same sort of the same purchasing power, they need to pay you slightly more money. So, essentially, things just cost more. You are not making more money in real terms.

[00:03:25]But now, let's have a quick look at the income tax bands again. So now, since you're making £52,000, a part of your income has now passed into this 40% tax bracket. Thus, meaning now, on part of your income, you're paying a 40% tax rate. Therefore, you're paying more tax, even though in real terms, you're not better off. So, therefore, in terms of this example, you actually become poorer in real terms.

[00:03:47]Your real income actually decreases due to fiscal drag. And this is the exact reason why Rishi Sunak, when he was the Chancellor in 2021, he froze his income tax bands. As it's estimated each year in 2025, it will bring the government 8.9 billion worth of tax revenue. And since they froze until 2029, it's estimated this will bring cumulatively it will bring the government almost 30 billion pounds worth of tax revenue.

[00:04:14]And why is this so clever? As this is a way the government can increase taxes without putting the headline out that tax rates have increased. Whereas in reality, even though you are paying more tax. So it's very clever by the government. But of course, so let's actually get on with answering the question. If you want to, you can start by defining fiscal drag. But if you want to be really transactional, really efficient, really quick, you can just get straight on with answering the question. So what is the main thing I've just explained to you? What is the main effect of fiscal drag? Of course, individuals are pushed into higher income tax bands. Therefore, the main thing is that they have a reduction in their disposable income. So that's the first thing I would say. And the first impact is there's a reduction in disposable income. Then explain why, like I've just said. So the way to structure answer to this question is firstly explain the concept of fiscal drag. And once you've explained the concept of fiscal drag, of course, fiscal drag ends at individuals in real terms, the the amount of income they are earning decreases. So therefore, as they're paying more income tax, it means that their disposable income is decreasing.

[00:05:12]And the question is asking the effects on AD. So it's very simple from here. If disposable income is decreasing, of course, that is going to lead to less consumption. And if there's less consumption, 100% very easy to do. Draw Add in a little ADAS diagram.

[00:05:26]So of course, on this AD diagram you can mention, since there's less consumption, consumption makes up around 60% of AD of the AD formula. Therefore, it causes AD to shift inwards to AD1, thus causing a decrease in real GDP.

[00:05:38]So of course, that is how to pick up your content knowledge marks and your analysis marks. But of course, if the question is referring to figure four and extract A, so I would just have a scan through figure four and extract A and just find any stats that are relevant and add them in. So, of course, this is a great start here. 250,000 more taxpayers were pushed into the additional tax band. Of course, that does represent the freezing of income tax bands. Represents fiscal drag. So, we've brought up fiscal drag and adding that bit uh that small example. Also, this last bit about the chancellor saying that um individuals making 150,000 will now pay um 1,200 more in income tax. And why is that? Of course, since we learn in figure four that um the band is decreasing from 150 to 125,000. Therefore, um the people who are making 150 will now that 25,000 pound extra will be taxed at 45% instead of 40%. So, two great bits of application there. Add them in, and that is how to get six marks on your KAA. And of course, on your eight-mark question, you will still have two valuation marks.

[00:06:33]So, let's try find some more valuation.

[00:06:35]Okay, so with regards to valuation, of course, like I always say, read through your chain of analysis, find any limitations, any assumptions, and evaluate them. First thing first is the main reason why and the room the question is about aggregate demand decreasing. That's the main link we're making in the question. But, the reason why in the question in the chain of analysis that aggregate demand decreases is due to less consumption. But, also, what are some of the other components of aggregate demand? Of course, the aggregate demand formula, which I hope you know by now, is C + I + G + X - M.

[00:07:06]Therefore, you could say how we evaluate this depends whether the reduction in consumption could be offset by the increase in government spending. Since, of course, this fiscal drag phenomenon is bringing the government lots more tax revenue. Therefore, with this massive increase in tax revenue, they could pump a lot more government spending into the economy. Therefore, that could actually reduce the effect on AD. Maybe cuz actually AD could shift out. So, it depends on the relative impacts of the reduction in consumption versus the increase in government spending. So, that's a really good and a really developed valuation point. Another valuation point is to do with fiscal drag itself. So, one of the main assumptions of fiscal drag is that wages will rise in line with inflation. But, for example, maybe one year there's 0% inflation rate, or even COVID, that our wage growth was around 6%. But, like I said, there was 8 months of consecutive double-digit inflation. So, wages were not rising exactly in line with inflation. Therefore, that limits the effects of fiscal drag as individuals are not dragged that much into higher tax bands since wages are not rising as much for them to rise into the next tax band. So, therefore, that limits the effectiveness the effect of fiscal drag as fiscal drag relies on inflation to increase individual wages that thus then being pushed into higher income tax bracket. But, yeah, that is enough for the eight-mark question. I think I've hit you with a lot of information in these last two questions, but it's a great paper for practice.