Economic Survey of Italy 2005: Economic performance and policy challenges

 

The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Italy 2005  published 18 May 2005. Chapter 1 identifies the challenges for which the subsequent chapters provide in-depth analysis and policy recommendations.

Is the Italian economy picking up?

In recent years, Italy’s GDP growth has been below the euro-area average, and total factor productivity growth has been very weak, and even negative. The OECD estimates that the potential growth rate of GDP, possibly only temporarily, has fallen below 1½ per cent. Consumer price inflation has been faster than in the euro-area and relative unit labour costs in both the non-traded and traded sectors have been rising steeply. On the positive side Italy is one of the very few OECD countries to have enjoyed robust employment growth every year since the turn of the century, and its unemployment rate has fallen substantially. Italy managed to respect the 3% Stability and Growth Pact limit on public deficits despite slow growth thanks to sizeable one-off measures. The latest pension reforms will help reduce the growth of public pension spending in future decades by raising the effective retirement age. However, the structural deficit is still significant, gross debt remains well above 100% of GDP, decentralisation is complicating the task of maintaining fiscal discipline, and repeated tax amnesties carry the risk of encouraging tax avoidance and evasion in the expectation of further amnesties. Substantial efforts are needed in coming years, both to assure effective implementation of a fully-funded €6 billion personal income tax cut that is planned for 2005, and to phase out completely by 2006 the one-off measures that reduced budget deficits in recent years. In sum, although Italy now seems to be recovering from the recessionary influences of the past 2-3 years, medium-term growth prospects seem poor, mainly because productivity growth and competitiveness remain weak. Italy’s ageing population will act as a further drag on per capita income growth in later decades, making harder the task of reducing both public-sector deficits and debt while increasing the need to do so.

What are the main policy challenges?

The challenges are thus to durably raise real per capita income growth rates and improve the public finances. Two main paths for policy are indicated:

  • Stimulate the supply side. A series of growth-enhancing measures are needed which should aim to: implement more forcefully policies that will put the non-traded sector under stronger competitive pressure to seek cost-saving innovations; reform bankruptcy legislation that maintains high exit costs for both creditors and firm owners, and corporate governance structures that encourage financial opacity; continue policies that encourage employment creation in the formal sector, while taking stronger measures to raise human capital at all ages.
  • Make determined efforts to reduce public debt and deficits on a permanent basis. Further savings can be made in public employment, government purchases and subsidies and it is especially important to ensure that decentralisation is implemented through efficiency-raising measures rather than duplication of posts. Continued forceful action is also required to prevent health spending from exceeding pre-agreed benchmarks. The tax base should be enlarged via simplification of the tax codes and more vigorous efforts to reduce evasion and avoidance. Tax rates should be reduced if and when they can be financed by permanent spending economies.

The prolonged period of slow growth is ending. Exports are picking up and the erosion of market shares in volume terms has slowed. Private consumption growth is expected to continue to outpace that of GDP, and there are signs that private investment demand is recovering. Employment growth remains positive and private sector wage claims remain moderate, especially in real terms. The short-term outlook is for continued moderate growth, with the output gap narrowing in 2006. There are signs, though, of financial stress in the manufacturing sector, which has yet to emerge convincingly from a 4-year long recession, and worries that Italy’s small enterprises in the traditional textile and footwear sectors are losing out to Asian and eastern European rivals, exacerbated by the strength of the euro and a domestic inflation rate that is higher than the euro-area average. And although Italy has a relatively low dependence on imported oil, a prolonged period of high oil prices would have a negative impact because of weaker demand in most trading partners and stronger domestic inflation pressures, and because Italy’s exports to oil-producing countries are small relative to GDP.

Why is productivity growth so weak?

Italy’s per capita income is about average for the EU and a little higher than the OECD average. Its relative ranking has slipped somewhat, essentially because its growth performance has weakened not only relative to its own past performance but also relative to that of almost all other OECD countries. More worrying, recorded total factor productivity growth seems to have been negative lately. One consequence has been that although wages have grown very little in real terms as perceived by employees (i.e. relative to the consumer price index), unit labour costs have risen quite significantly for their employers. For several years now, Italy has thus been losing price competitiveness within the euro-area, and recently even more sharply against non-euro-area countries as the euro has strengthened. Export volumes have fallen, and market shares in real terms have been eroded. Italian producers face heightened competition from eastern European and Asian countries on both the export and domestic markets. This process appears to be continuing: inflation in Italy is higher than the euro-area average, the output gap is closing, and although productivity performance is projected to pick up with the cyclical recovery, there are no early signs that it is going to do so rapidly. It is therefore important to understand the reasons for this poor productivity performance, and to find policies that will improve it.

Productivity decomposition
Annual growth rates


Source: OECD (2004), Economic Outlook database No 76.

Real exchange rates and export market shares


Source: OECD Economic Outlook 76 database.

An alternative (but less than fully convincing) interpretation of recent employment, output, and trade statistics is that there are measurement problems. For example, employment growth may be overstated as informal labour “emerges” into the formal sector. However, a reason why this interpretation is less than fully convincing is that national accounts data already include estimates of the informal economy, which therefore cannot represent a significant source of bias in the productivity statistics. Employment costs may be overstated as tax credits for contract conversion are registered as higher profits rather than lower labour costs and growing use of flexible labour contracts reduce non-wage rather than wage labour costs, while output may be understated because of quality improvements. Cyclical labour hoarding may have also played a role in the deceleration of productivity. However, persisting relatively high core inflation and relatively large current account deterioration suggest that there is a structural – rather than just a measurement or a cyclical – problem with productivity and competitiveness in Italy. It would therefore be wise to base policy decisions in such an important area on the awareness that those structural problems are at the origin of the slowdown in economic performance. This is even more the case when the appropriate policy actions are ones that are desirable in themselves.

Why has employment growth been so strong?

Statistically, the reason why per capita incomes have continued to rise a little in the past few years, despite apparently falling total factor productivity, is that employment creation has been vigorous. Indeed, more jobs were created in the recession years 2001-2004 than in the preceding 4 years of brisker GDP growth. The unemployment rate fell in each year of the recession, and is now below the estimated NAIRU. The labour market reforms of earlier years and more recently led to the increase in employment, although employment data may have been somewhat boosted by flows of previously under-recorded informal labour, especially newly regularised immigrant labour, into the formal force. The reforms have made it easier and cheaper to adjust enterprise labour forces via temporary contracts, and tax incentives have facilitated their conversion to permanent contracts. Thus employers have been more willing to take on low-skilled or inexperienced employees on flexible contracts, which have allowed them to gain work experience and build up skills, without them necessarily remaining indefinitely in a state of precariousness. The large increase in employment, particularly of the low-skilled, goes some way to explaining the weak growth of productivity. But the example of other countries, for example the United States before 2001, and especially Ireland, shows that it is possible to have strong growth in both employment and in total factor productivity for a prolonged period. Competitive product markets seem to be needed as well as flexible labour markets.

What are the priorities for reforms to labour markets and social policies?

Although employment has risen substantially since the late 1990s, and unemployment rates have fallen, overall employment rates in Italy remain low, as do participation rates. The overall participation rate for those of working age is 63%, compared with an EU average of close to 70% (and a US figure of 75%). As in most countries, participation rates for prime-age males are well above 90%, but the figure drops to barely over 30% in Italy for males over 60 years old. Female participation rates are low by international comparison at all ages. Less than 50% of women are in the labour force compared with an EU average of 60%. And as in other southern European countries, part-time employment of women accounts for a relatively low proportion of their total employment. Participation rates of women and older males are lower than the EU average even in the prosperous Italian regions that experience chronic labour shortages. There is therefore considerable room for expanding output for some time to come by raising participation and employment rates of women and older males, including in the northern and central regions, towards international levels.

Employment rates

1. Excludes Luxembourg in 2003.
Source: Employment Outlook Database.

The pension reforms should help raise participation among the older workers in future years, though it is important that higher participation is accompanied by higher employment. Adequate training for workers before they reach the vulnerable age will be important, and the public employment service should strengthen efforts to find jobs for the unemployed in this age group. The actual impact of the reforms on participation of older workers should be monitored. As in other Mediterranean countries, there is a traditional culture of women staying at home to look after their children, and to care for their ageing parents. Concerns about the low rates of female participation can be addressed by greater public investment in child-care facilities and care support for the elderly in order to help women stay in paid work. The high tax wedge on labour should be reduced, while the tax allowances for dependent spouses should be reformed in order to strengthen the financial incentives to work for second earners, especially those with low skills. Many immigrants are working as domestic help, potentially liberating their higher-skilled employers to join the labour force. Liberalisation of immigrant flows could help facilitate this process. Recent labour market reforms have increased the supply of part-time jobs, which may be particularly attractive to women. Liberalisation of opening hours in the retail sector, and encouraging the spread of large retail outlets, as well as reforms in other product market areas, would further expand job opportunities for women along similar lines.

Education levels and labour force participation
Per cent 

Source: OECD, Employment Outlook database; Eurostat, New Chronos.


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