Price rises affect expenditure, but also revenue. How can the fiscal drag be offset?

The Budget Policy Document (DPB) lists household purchasing power, investment, defence and energy security among its priorities. But the question is: how much of the additional resources will go back to workers who have suffered from fiscal drag? The document does not yet provide an answer, but it helps to explain how inflation has financed public spending and why part of these resources should be returned. According to our estimates, which have been broadly confirmed by the Ministry of Economy and Finance (MEF), the fiscal drag resulting from the failure to index personal income tax (IRPEF) in the two-year period 2026–2027 amounts to approximately 8.3 billion, of which 4.7 billion in 2026 and a further 3.6 billion in 2027. 

The European Commission considers the failure to index tax brackets to be discretionary revenue. The reference is not to the previous year’s revenue, but to what the state would have collected had it indexed the tax to inflation. The difference represents additional revenue that can be used in the calculation of net European expenditure. Fiscal drag is already factored into the trend figure and cannot be counted again to cover further measures. However, precisely because it is included in the accounts, it has created budgetary scope, offsetting part of the increased expenditure generated by inflation.

But inflation also drives up public spending. Some expenditure items are linked to prices: first and foremost, pensions (+7.5 billion), with different revaluations depending on the amounts; then the universal child allowance (+600 million), certain family benefits and unemployment benefits. To this are added interest payments on index-linked government bonds, the revaluation of civil servants’ severance pay (TFR) and, under certain conditions, price adjustments in public procurement contracts. Our estimate suggests that unexpected inflation could lead to approximately 8.9 billion in additional expenditure in 2027, rising to 10 billion when using the scope outlined by Meloni in her letter to the European Commission.

Compared with the forecasts for the end of 2025, the additional fiscal drag caused by higher inflation amounts to around 3.6 billion: a significant offset, albeit insufficient to cover all the increased expenditure. There are also other revenue streams generated by inflation, starting with VAT. It is peculiar to portray inflation solely as a source of increased expenditure, whilst ignoring the resulting increase in revenue. The call for European flexibility must take both effects into account. Revenue from fiscal drag cannot be used in the calculation of net expenditure and then ignored when quantifying the costs of inflation. The Draft Budgetary Plan (DBP) shows that, net of the safeguard clause, net expenditure remains compatible with European limits. The projected growth rates, excluding the increases permitted under the clause, are 1.9 per cent in 2027, 1.7 per cent in 2028 and 1.5 per cent in 2029. Expenditure growth is slowing, without falling in absolute terms. The document acknowledges that the new treatment of discretionary revenue, including fiscal drag, has improved the calculation of the indicator.

Fiscal drag therefore helps to keep public finances in order, but it weighs on the tax burden, which is forecast to reach 43 per cent of GDP in 2027, compared with 42.9 per cent in 2025. The 8.3 billion is equivalent to around 0.35 percentage points of GDP; its contribution to the tax burden is far from marginal. Our proposal is to neutralise the fiscal drag, as many countries do, by index-linking income tax brackets and allowances. But this is unlikely to happen, given its importance for public finances. How, then, can these resources be returned?

One option is to raise the threshold above which the maximum personal income tax rate of 43 per cent applies from 50,000 to 60,000 euros. This would amount to a partial rollback, focused on middle-to-high and high incomes. Those earning less than 50,000 euros would not benefit. Those earning over 60,000 euros would receive the maximum benefit, subject to offsetting mechanisms. If this measure were abandoned in favour of extending the flat tax from 80,000 to 100,000 euros, it would be a paradox: those on the flat-rate scheme have not suffered tax drag because they pay a proportional tax – a ‘flat’ tax, in fact.

Exempting pay rises under national collective agreements from tax partly offsets the tax drag, but presents more problems than benefits. The trade unions’ support for this is inexplicable: applying a substitute tax to pay rises amounts to introducing an incremental flat tax on employment. Two workers on the same salary could end up paying different amounts of tax simply because one has received a more recent pay rise. This fragments the personal income tax base, reducing progressivity and transparency and creating inequalities between workers and sectors. Furthermore, once introduced, the tax relief would be difficult to remove without reducing wages.