Inflation and fiscal drag: lessons for Italy from the United States

The rise in the tax burden is the most worrying aspect of the Budget Law. We are now at 42.8 per cent, almost at the levels seen under the Monti government. Not everything can be explained by fiscal drag. But to understand what is happening in Italy – and why taxes are not falling despite rate cuts – we must start here: with a mechanism that other countries have learnt to neutralise, whereas we have not. In recent days, American taxpayers have received notification of the update to the "federal income tax brackets" because, since 2018, the United States has been indexing income tax to inflation, thereby neutralising fiscal drag.

Let us imagine two countries, the United States and Italy, both experiencing 20 per cent inflation between 2020 and 2025. In the early years, in both cases, nominal wages remain static. Then, in the third year, in the United States, nominal wages catch up with the new price level and so real wages (purchasing power) return to their starting point. In Italy, however, nominal wages rise by only 12 per cent. Consequently, real wages remain 8 per cent lower than in 2020. This is where the difference between the two tax systems becomes crucial. In the United States, tax brackets and allowances are automatically indexed to inflation. This means that, if nominal wages remain static but prices rise, the system ‘neutralises’ the tax drag: you do not pay a higher proportion of tax simply because everything costs more. Thus, whilst wages lag behind, the tax burden is temporarily reduced – only to gradually return to its original level once real wages have caught up with prices. In Italy, the opposite happens. The system is not index-linked: tax brackets and allowances remain fixed. Consequently, even if purchasing power does not increase, nominal income rises and ends up pushing part of the taxpayer’s income into higher tax brackets. It is as if the tax authorities were taxing not real wealth, but inflation. The result is that the tax burden increases and does not reverse, in the absence of further legislative changes to the tax system.
This is the theoretical and practical explanation for the rise in Italy’s tax burden. Of course, both countries have implemented tax reforms. But whilst the United States has used them to reduce taxes further, Italy has merely mitigated the effects of inflation. The government has reduced personal income tax rates and made the effect of the social security contribution relief permanent, but the overall tax burden has not fallen. It is true that the government has reduced taxes for low earners, restoring the fiscal drag and also part of the purchasing power lost from wages and not recouped through contract renewals; however, for incomes above 35,000–40,000 euros gross per annum, there has been no tax reduction whatsoever. On the contrary, there has even been an increase, partly due to the cut in tax allowances, and so the tax drag is still very much in place and adds to the loss of purchasing power from wages.

Does fiscal drag account for the entire increase in taxes? Obviously not. If income does indeed rise, a larger proportion of tax is due. But fiscal drag refers to the portion of tax that is ‘undue’: the amount paid simply because the system has not been updated. How is it measured? In theory, one need only compare the actual tax burden with what it would have been had we had an ‘American’ system. Today in Italy, the tax burden stands at 42.8 per cent of GDP, its highest level in the last ten years. In a system that had neutralised fiscal drag, the reforms implemented by the government would have led to a reduction in the tax burden. Admittedly, employment has also grown in recent years and the fight against tax evasion has improved. But the economic story of the three years following the end of inflation is this: a system that fails to adjust the progressive tax structure in line with rising prices ends up turning inflation into a silent tax increase.

The paradox is that the government claims to have cut taxes, yet it is taking in more revenue than before. This is the accounting effect of the tax drag: whilst wages are stagnating, progressive taxation generates revenue. In a country that already has a high tax burden, this is not good news. Neutralising the tax drag is not a left-wing or right-wing idea; it is a rule of fiscal common sense. Italy did this in the 1980s, but then forgot about it. Until this mechanism is addressed, every time prices rise, taxes will rise even more. And every time, governments will claim to have cut them, when in reality they will have simply let inflation do the dirty work for them.