Inflation drives up personal income tax: 35.4 billion in fiscal drag in the 2026–2029 accounts

Inflation, which has quickly returned to the fore following the sharp spike of 2022–23, is putting a strain on public finances on the expenditure side, as it drives up spending on pensions, the universal child allowance, public sector procurement and interest on the national debt. But it is also providing a boost to revenue, driving up VAT and personal income tax receipts: the driving force behind personal income tax is ‘fiscal drag’, that is, the revenue generated by the nominal increase in incomes caught up in the frantic race to keep pace with rising prices.

The issue is set to reignite the debate surrounding the budget. All the more so after, as reported in yesterday’s *Il Sole 24 Ore*, the majority meeting at the Ministry of the Economy has cast serious doubt on the ‘IRPEF cut for the middle class’, that is, on the proposal to raise the income threshold at which the 33 per cent tax rate applies from 50,000 to 60,000 euros. The idea is popular with a cross-party bloc ranging from FdI to Forza Italia. But it is also costly, requiring 2.7 billion a year from a budget which, excluding the extra deficit allowed under the fiscal clause, may not exceed 7–8 billion in total, funding permitting. ‘We absolutely must go ahead with the new income tax cut,’ commented Forza Italia’s Deputy Prime Minister Antonio Tajani yesterday. ‘No decision has yet been taken,’ confirmed Deputy Minister for the Economy Maurizio Leo. The issue is political: under discussion is an alternative proposal to provide support for the elderly and vulnerable, involving a sort of flat-rate advance to offset healthcare costs, accompanied by a birth rate fund, which, according to some in the majority, could prove to be more directly ‘visible’ to beneficiaries, and thus have a greater impact in terms of public support – a highly sensitive issue just a few months ahead of highly uncertain general elections.

The resurgence of the term ‘fiscal drag’ forms part of this debate. But there is one essential caveat: revenue generated by fiscal drag does not provide funding. The additional personal income tax (IRPEF) generated by the nominal increase in incomes is, in fact, included in the long-term public finance projections – that is, in the deficit and debt levels under current legislation, as calculated by the DPFP approved yesterday by both Houses of Parliament together with the report on the deviation. A portion of the expected increase in revenue (+9.3 per cent) from direct taxes between this year and 2029 stems from this. In calculating the net expenditure trajectory, the fiscal drag plays a key role in preventing the trajectory agreed with the EU: but since the long-term trends follow the line set out in the Structural Budget Plan to the letter, it does not open the door to additional expenditure. The estimates carried out by the Ministry of the Economy – which have been brought back to the forefront of the parliamentary debate following repeated questions raised by Maria Cecilia Guerra (PD) – seek to assess the impact of the new personal income tax (IRPEF) on fiscal drag.

This year, it is expected to generate 4.4 billion euros; a further 3.4 billion would be due next year; 2.4 billion is allocated to 2028; and 2.8 billion is earmarked for 2029. The revenue for each year is repeated in subsequent years, with the result that the 4.4 billion from 2026 is carried over to 2027, 2028 and 2029, whilst 2027 adds 3.4 billion, which is repeated in the two-year period 2028–2029, and so on. In cumulative terms, the fiscal drag would therefore amount to 35.4 billion over four years. That is no small sum. However, adjustments made as the budget is implemented over the coming years could result in even higher figures. The Public Finance Policy Document is based on the inflation recorded up to August by the FOI index – the one covering ‘blue-collar and white-collar households’ – but the September update, due out the day after tomorrow, is already expected to show a further rise; in a trend that many forecasts suggest is set to continue, barring any now-unlikely shifts in the Middle East scenario. Be that as it may, on the subject of tax revenue, the DPFP merely writes another instalment in a series that has already enjoyed considerable success in recent years.
The Parliamentary Budget Office has calculated that between 2021 and 2023, inflation generated additional revenue of 25 billion per year, and that the IRPEF reforms, with tax rate cuts for the lowest earners, have fully offset this for those declaring up to 32,000 euros a year. However, without index-linking the tax bands, this effect is repeated every year; and without further changes to personal income tax, it hits the lower income brackets – previously protected – as well as the middle class, which has so far been left without a safety net.