Economy
THE ANALYSIS •
Fiscal drag is back. Inflation is returning and hitting the usual suspects
This time, the tax drain amounts to between 2.5 and 5 billion. The risk is that, once again, it will be employees and pensioners who foot the bill, having already been hit by delays in contract renewals and a loss of purchasing power
(Photo: Getty)
Istat has confirmed that inflation returned to 3.3 per cent in August on an annual basis. Last year, the Bank of Italy envisaged a stable outlook: cumulative inflation for the two-year period 2026–2027 at around 3 per cent. Following the energy crisis, the outlook has become more challenging: around 4.4 per cent cumulative. In adverse scenarios, the figure could exceed 6 per cent.
When inflation strikes, the government suffers a political blow but reaps two immediate benefits. The first is that the debt-to-GDP ratio falls more readily. The second is that tax revenue increases due to indirect taxes (VAT) and direct taxes (personal income tax). The latter rise if wages and pensions keep pace with prices, whilst tax brackets and allowances are not indexed. This is ‘fiscal drag’, an invisible tax. The tax burden is forecast to rise by 0.3 percentage points next year: we will end up paying for the abolition of motor vehicle tax through higher taxes.
The issue is who bears the cost of inflation. If the shock stems from imported raw materials, the country is worse off. But how is the loss shared out? In 2022/2023, the adjustment was borne by fixed incomes: employees and pensioners, particularly those earning over 35,000 euros gross per annum, lost purchasing power and suffered from fiscal drag. Businesses protected their profit margins, whilst the tax authorities collected the windfall revenue, which they then ‘returned’ in the form of tax cuts.
There is a risk that this will happen again in 2027. The collective bargaining system has not been rectified, and when inflation strikes, companies have an incentive to wait: every month that goes by without a pay rise reduces real wages and lowers labour costs. And so the renewal of collective agreements can be put on hold.
The figures on fiscal drag in 2027 give an idea of the scale involved. With cumulative inflation for 2026–2027 at 3 per cent, there is a fiscal drag that we shall call ‘physiological’ because personal income tax (IRPEF) is not index-linked. If inflation over the two-year period rises to 4.4 per cent, the tax authorities will collect an additional 2.5 billion in fiscal drag. With inflation at 6 per cent, the figure rises to 5 billion. These are estimates based on a fully index-linked personal income tax, but they are conservative as they do not include regional and local surcharges.
Then there is the public debt. Here, we must avoid the biggest misunderstanding. To say that inflation reduces the real value of the debt does not mean that the Treasury ‘saves’ that amount in the year’s budget. Interest and the principal on maturing securities must be paid. The benefit to the state lies in the real loss suffered by holders of non-index-linked nominal securities. Anyone who is repaid the principal of a maturing government bond following a period of inflation loses out because that principal is now worth less.
Loans maturing between June 2026 and December 2027 total 510 billion, approximately one-sixth of the 3,100 billion in public debt. Of this amount, only 20 billion relates to index-linked bonds. This leaves 490 billion in nominal securities. For each security, we have calculated the cumulative inflation from 2025 to the maturity date, using the Bank of Italy’s forecasts for 2026/2027 across three scenarios: 3 per cent, 4.4 per cent and 6 per cent. If inflation over the two-year period rises from 3 per cent to 4.4 per cent, the real value of the maturing debt falls by 4 billion; if it reaches 6 per cent, it falls by 9 billion. These are the figures the state would have had to pay had those securities been index-linked.
But the government isn’t finding billions in its coffers. It is a reduction in the real value of the debt already issued. And the calculation does not take into account that the new bonds issued to replace those maturing will have higher interest rates. On the other hand, there is fixed-rate interest. Those who have lent money to the state receive nominal euros, but those euros buy less. If the average nominal yield on the debt remains around 3 per cent and inflation rises to 4 per cent, the ex post real yield is around -1 per cent. Given that, out of 3,100 billion in debt, approximately 2,300 billion is fixed-rate and non-indexed, this amounts to a real loss of around 23 billion for bondholders: an implicit transfer from creditors to the state. This redistribution between creditors and the public debtor is normal in times of inflation. It should not be interpreted as a budgetary saving, but as a redistribution of wealth – one that is inevitable and limited to the short term, until the inflation surprise is factored into new interest rates.
However, the decisive political choice regarding who bears the costs of inflation remains that concerning collective agreements and fiscal drag: to prevent, as in 2022/2023, almost the entire cost from being passed on once again to employees and pensioners.