The forthcoming Budget Bill must address fiscal drag

Now that we have new inflation forecasts, we can analyse one of the most important – and least visible – items in the forthcoming Budget Bill: fiscal drag. When prices and nominal wages rise but income tax brackets, allowances and deductions remain unchanged, part of the increase in real incomes is automatically absorbed by the tax authorities. There is no need to raise a tax rate: it is enough simply not to index the system.

Applying the new inflation forecasts to the available tax returns yields a significant result. In the Bank of Italy’s baseline scenario, with cumulative inflation of 5.2 per cent in 2026 and 2027, the fiscal drag amounts to 8.11 billion: 5.76 on employees and 2.35 on pensioners. With inflation at 6 per cent (adverse scenario), revenue would rise to 9.35 billion; at 8.2 per cent (severe scenario), it would reach 12.74 billion. These are conservative estimates, as they do not include regional and local surcharges.

But gross fiscal drag is one thing; the additional resources that can provide further scope for a Budget Bill are quite another. Even with inflation close to 2 per cent, the tax system inherently generates fiscal drag. In our calculations, we take approximately 4.7 billion in ‘natural’ fiscal drag as a reference. This forms the basis included in the trend figures and cannot be counted as extra revenue.

The truly interesting figures are therefore those net of that 4.7 billion in inherent fiscal drag. In the base-case scenario, of the total 8.11 billion, around 3.4 billion represents additional revenue. With inflation at 6 per cent, this rises to 4.6 billion. In the most severe scenario, the figure reaches around 8 billion. This is the potential fiscal ‘dividend’ from inflation.

This distinction is even more important under the new European rules. The Stability Pact now monitors net expenditure trends and excludes, amongst other things, the effect of discretionary measures on revenue. The European Commission regards the increased revenue from fiscal drag as a discretionary fiscal policy measure (equivalent to a tax rate increase), which therefore allows greater scope for growth in public spending. This means that fiscal drag could be an important source of funding for the 2027 Budget Bill.

It is only an apparent paradox. The government can announce a reduction in tax rates whilst at the same time collecting billions more because inflation pushes nominal incomes into higher tax brackets and reduces the real value of tax allowances. The tax burden can increase without Parliament having voted for an explicit tax rise. When inflation was low, the problem was almost invisible. Following the shock of recent years, this is no longer the case. If purely nominal increases in incomes are not to automatically translate into tax increases, then the issue is not merely how to deal with the extraordinary fiscal drag, but whether to neutralise the mechanism at its root.

The approach the government is discussing is much more limited in scope: extending the benefit of the 33 per cent personal income tax rate up to 60,000 euros, by adjusting the tax bracket between 50,000 and 60,000 euros. However, compared with fiscal drag, this is only a partial, one-off compensation: it gives something back to a section of taxpayers, without altering the mechanism that generates the annual tax drain.

There is also a political issue. Concentrating the tax relief between 50,000 and 60,000 euros exposes the government to criticism that it is channelling the few available resources towards middle-to-high earners. A reduction limited to that bracket produces concentrated benefits, whilst the fiscal drag affects a much broader section of the income distribution.

The alternative is more general: to index, either entirely or at least to a large extent, tax brackets and allowances to inflation. It would no longer be a matter of deciding each year who to ‘cut taxes for’, but of establishing that a purely nominal increase in income should not be taxed as if it were a real increase. Of course, this would come at a cost: it would mean foregoing not only the additional 3.4 billion in the baseline scenario, but also the inherent fiscal drag that currently factors into the trend figures.

This is the real crux of the forthcoming budget. Even before discussing how to spend the fiscal drag, we must decide to what extent it is legitimate to continue treating it as an ordinary source of state funding. In the base-case scenario, between the structural and additional components, over 8 billion is at stake. When an automatic tax reaches this scale, it becomes difficult to continue treating it as if it did not exist.