Meloni calls for flexibility within the EU regarding inflation, but does not take fiscal drain into account

Fiscal drag provides the government with a source of funding that deserves to be made explicit. For 2026 and 2027, revenue of 8.3 billion is estimated to result from the failure to index-link personal income tax (Irpef). According to the European Commission’s criteria, this component falls within discretionary revenue, which contributes to the calculation of net expenditure. The question is how this is accounted for in the public finance tables and for what purposes the government intends to use it. Whilst inflation increases certain expenditure items, the failure to index personal income tax also has a favourable effect on the calculation of net expenditure. Considering only the former, as in the request for flexibility put forward by Meloni, leaves out a significant part of the picture.

In the debate on fiscal drag, two questions overlap. The first concerns the effect of inflation on taxation: by how much do taxes increase when nominal incomes rise whilst tax bands and allowances remain fixed? The second concerns the comparison with an index-linked tax system: how much revenue does the state retain by failing to adjust tax rates in line with prices? For the purposes of accounting for discretionary revenue under European rules, it is this latter aspect that is decisive. The Commission uses the annual adjustment of personal income tax (IRPEF) bands to inflation as the benchmark, even in countries that do not usually index them. The failure to index is thus treated as a measure that increases revenue relative to that benchmark. This criterion, set out in the Report on Public Finances in the EMU 2024, ensures consistent treatment across countries with different indexation regimes. An important consequence follows. Even if nominal wages remain unchanged, the failure to index can be recognised as an increase in discretionary revenue. The tax burden does not increase compared with the previous year, but it is nevertheless higher than it would be if the tax were adjusted for inflation.

Quantification for the purposes of European rules therefore does not require proof of an actual increase in wages equal to inflation. The indexation criterion is applied to the reference tax base, using the change in prices. The debate on income trends and the tax burden, whilst important for assessing who has borne the cost of inflation, is not relevant to the issue of accounting for fiscal drag. For the two-year period 2026–2027, estimates stand at 4.7 billion in 2026 and 3.6 in 2027: 8.3 billion in total. This is the fiscal drag component to be included in the trend in net expenditure based on updated price forecasts. The Dpfp illustrates how significantly this criterion can affect the indicator. The growth in net expenditure for 2025 is revised downwards from 1.9 per cent to 1.5 per cent, compared with a target of 1.3 per cent. The document attributes this adjustment primarily to the alignment of the quantification of discretionary revenue with European criteria and notes that this will also contribute to the figure in 2026.

However, the link between fiscal drag and the aggregates remains unclear. In Table II.1.4, discretionary revenue amounts to 0.1 per cent of GDP in 2026 and 0.2 per cent in 2027, equivalent to approximately 2.3 and 4.8 billion respectively. These are aggregate figures, which may include measures with opposing effects and do not necessarily correspond solely to fiscal drag. This discrepancy requires an explanation. Fiscal drag recognised as discretionary revenue can offset higher expenditure in the calculation of net expenditure and help to absorb the effects of inflation without altering the path agreed with Europe. However, the 8.3 billion does not automatically constitute additional fiscal space: if it is already factored into the trend figure, its contribution is already included in the indicator.

The political question is how this contribution is used. If the government retains the fiscal drag to finance expenditure, it must take this into account when quantifying the inflationary costs for which it is seeking flexibility. Any resulting increase in unfunded expenditure must be calculated net of this compensation, without counting the same resources twice. If, on the other hand, the government were to decide to return the fiscal drag to taxpayers, it would forgo its contribution to the financing of expenditure. The request for flexibility would then have a clearer rationale: to support the increased expenditure without passing on the cost to income tax payers. Retaining the fiscal drag and presenting inflation solely as a burden on the public finances amounts to offering an incomplete picture of the situation.