The Hidden Inflation Tax: How Non-Indexation of Income Tax Generates a Silent Fiscal Expansion

In environments where consumer prices rise significantly, firms adjust nominal wages, households incur higher costs, and governments face renewed pressures on public spending. Yet underneath this conventional inflation dynamic emerges another, less visible shift: when tax systems retain fixed nominal thresholds while incomes grow nominally, the result is a revenue surge not tied to improved productivity or real income growth, but to tax bracket creep. This phenomenon, often labelled as fiscal drag, occurs when inflation pushes taxpayers into higher tax brackets or phases without any legislative change in nominal rates or thresholds.

Spain’s experience since 2022 provides a compelling case study. After the 2021 recovery, consumer prices rose notably between 2022 and 2024. Yet the personal income tax (IRPF) thresholds were not adjusted. The consequence: a silent increase in effective tax burdens and a consequential rise in tax revenue without formal tax policy reform. Using data from the National Statistics Institute (INE) and the Spanish Tax Agency (AEAT), an illustrative scenario has been computed wherein the IRPF brackets were deflated (indexed) to preserve their real value as of 2021. The results are striking.

Table 1. Estimated Fiscal Impact of Non-Indexation of Personal Income Tax Brackets, 2022–2024

Year	Tax revenue (M€)	With PIT deflation adjustment (M€)	Difference
2022	109.485	104.853	+4.632
2023	120.280	111.663	+8.617
2024	129.408	118.353	+11.055

Source: Author’s calculations based on data from the Agencia Estatal de Administración Tributaria (AEAT) and the Instituto Nacional de Estadística (INE), Consumer Price Index-Annual averages (Base 2021 = 100).

Between 2022 and 2024, the cumulative extra revenue would approach €24 billion, attributable solely to the decision not to index the tax brackets. The divergence is visually clear: one line reflects actual IRPF revenues; the offset line reflects the counterfactual deflated-bracket scenario.

The Mechanism of Fiscal Drag

The theoretical foundations extend from the early work of Tanzi, who analyzed how inflation and collection lags affect real tax yields: when tax liabilities are fixed nominally, inflation erodes the collection base and shifts burdens unpredictably (Tanzi, 1977). Later, Auerbach & Hassett (2015) discuss how taxation of capital and labor must account for inflation-driven distortions, even in advanced economies, if one seeks neutrality in tax incidence. Together, these works imply that non-indexation of tax thresholds activates a hidden fiscal expansion mechanism.

In practice, Spain’s policy choice transforms nominal wage growth into higher tax bracket occupancy, reducing disposable income in real terms and increasing public receipts without any statutory rate change. From a governance perspective, indexation is not a tax cut, but rather a mechanism to maintain neutrality and transparency.

Empirical and Comparative Evidence

Empirical research consistently confirms that non-indexation tends to impact middle-income households most heavily, since they are more likely to cross thresholds due to nominal inflation rather than real income growth. For instance, Tanzi (1977) shows theoretically that short collection lags and elastic tax systems amplify inflation-driven real revenue changes. Auerbach & Hassett (2015) highlight the risk of taxation systems becoming inadvertently more burdensome when nominal incomes rise but thresholds remain unchanged.

Figure 1. Actual and Deflated Personal Income Tax Revenues in Spain, 2022–2024

Source: Author’s calculations based on data from the Agencia Estatal de Administración Tributaria (AEAT) and the Instituto Nacional de Estadística (INE), Consumer Price Index-Annual averages (Base 2021 = 100).

Fiscal and Policy Implications

When tax brackets are not indexed, inflation becomes a disguised tax increase: it elevates the tax burden on unchanged or modestly rising real incomes, shifts burdens onto households without formal debate, and undermines the transparency of fiscal policy. The economy thereby experiences a structural upward drift of tax burdens, which may discourage labor supply, dampen consumption and investment, and erode trust in the tax system.

From a macro-fiscal vantage, non-indexation introduces a pro-cyclical tightening mechanism: during inflationary phases, real disposable income shrinks faster than expected, consumption is dampened, but tax revenues surge. When inflation later recedes, the higher nominal tax base may persist, locking in a permanently higher tax burden unless thresholds are explicitly reformed.

Indexation of tax thresholds is not a mere technical detail; it is a governance requirement for equitable and predictable taxation. To restore trust in tax systems, thresholds must reflect real incomes, not merely nominal growth.

Between 2022 and 2024, Spain’s choice not to index the IRPF transformed inflation into a fiscal instrument. While the policy may have eased short-term budget pressures, it also risked reducing households’ purchasing power, undermining incentives, and obscuring the real stance of fiscal policy.

Inflation is inherently a tax on savings; when combined with non-indexation, it becomes a tax on income too. A tax system that allows inflation to shift burdens without oversight undermines the principle that taxation should reflect a person's real capacity to pay.

References

• Auerbach, A. J., & Hassett, K. A. (2015). Capital Taxation in the Twenty-First Century. American Economic Review, 105(5), 38-42. DOI: 10.1257/aer.p20151058.

• Tanzi, V. (1977). Inflation, Lags in Collection, and the Real Value of Tax Revenue. IMF Staff Papers, 24(1), 154-167. DOI: https://doi.org/10.1017/CBO9780511895661.008