The impact of government policies on inflation

At 3.2% in 2024, Dutch inflation was above the euro area price stability target of 2% and also above the euro area average, which stood at 2.4%. This trend is expected to continue in the next few years (see Figure 1). While the Netherlands is currently in a good position to deal with temporary higher inflation, this should not become the new normal. After all, if inflation stays high for much longer, inflation expectations may also rise, leading to higher wage demands and prices, and eroding the Netherlands’ competitive position in the long run. It is therefore important to prevent these expectations from becoming entrenched in the economy.

European monetary policy is unlikely to contribute much to bringing down the relatively high inflation in the Netherlands. This is because the ECB’s policy strategy focuses on the average inflation rate in the euro area, which is expected to return to the 2% target this year. Bringing Dutch inflation down therefore requires concerted efforts from employers and unions (the social partners) and the government. This is because the social partners have an impact on domestic inflation through wage and profit increases, and the government through taxes and public spending.

Impact of fiscal policy on inflation varies for each measure

In a new analysis, we examine which government measures have the biggest impact on inflation and through which channels the inflation effects occur. Figure 2 shows the impact on inflation of various spending increases (left) and tax cuts (right) by 1% of GDP (i.e. around €12 billion). We used our macro model DELFI to prepare these estimates.

The impact on inflation varies significantly for each type of measure. For instance, spending measures with a high impact on labour market tightness, such as increasing public-sector employment, have a relatively strong effect on inflation. Measures that strongly stimulate demand for domestic goods, such as expenditure on goods and services (e.g. office supplies and maintenance costs), also have a relatively high inflationary effect. Income transfers (such as social benefits) have a more moderate effect because they are partially saved. The impact of investment is limited because this consists for a relatively large proportion of imports and also increases production capacity, which has a dampening effect on inflation.

On the tax side, the impact of indirect taxes (such as VAT and excise duties) stands out in particular. Such taxes have a significant immediate effect on prices. Direct taxes (such as wage tax) have a more moderate effect on inflation. This is mainly because there are two channels working against each other. On the one hand, lower wage tax leads to lower production costs and thus lower prices, but on the other hand, it also leads to higher net wages and more consumption. Higher consumption actually drives up prices.

Thus, when assessing policy measures, it is prudent to take into account their expected impact on inflation. This analysis supports a proposal (Dutch) recently adopted in the House of Representatives calling on the government to consider the impact on inflation in its financial and economic policy-making by providing guidance on how to estimate the inflation impact of different policy measures.

This is especially true now that the economy is in a boom phase, which strengthens the inflationary impact of most measures. According to our model estimates, the impact of higher spending on inflation is approximately 1.5 to 2 times greater than in regular times. The effect of tax measures on inflation is also larger during periods of economic boom. This is because in a tight economy, there is little extra production capacity to absorb the additional demand for goods and services, leading to stronger price increases. Sticking to trend-based fiscal policy avoids adding fuel to the fire. Moreover, this builds up buffers in good economic times, which can be used for economic stabilisation in bad times.