Economic Survey of Italy 2005: Fiscal reforms for credibility and growth

 

The following OECD assessment and recommendations summarise chapter 2 of the Economic Survey of Italy 2005  published 18 May 2005. It covers one of the main challenges identified in chapter 1.

Should fiscal deficits and debt be reduced?

As with many other EU countries, Italy’s public finances deteriorated when growth slowed abruptly late in 2001, but the authorities continued to respect the 3% of GDP reference value of the Stability and Growth Pact, resorting to asset sales and one-off measures with limited demand impact, notably tax amnesties. The recovery will bring some fiscal improvement, but not enough by itself for Italy to remain under the 3% limit. In any case, there has been a trend deterioration in the underlying fiscal position since before the 2001-2003 slowdown, with the cyclically-adjusted primary surplus falling from around 6½ per cent of GDP in 1997 to an estimated 2% by 2004 because of a strong upward dynamic in public spending. The OECD projects further falls in 2005 and 2006 on the basis of announced policy measures, with the public-sector deficit exceeding 3% of GDP in 2005, more so in 2006. This is despite the policy of capping current public spending growth (except on pensions) at 2% for 2005, together with revenue-enhancing measures. Sales of public assets, especially real-estate, are set to continue, and prior securitisations of such sales will continue to help net borrowing in 2005. Reaching the official budget goal of a 2.7% deficit for 2005 may require additional consolidation measures as well as close monitoring of anti-evasion programmes and adherence to the spending caps.

Fiscal balances
  Per cent of GDP 

1. Current and capital spending, excluding interest payments. 2. Includes all one-off measures (recorded as negative outlays) aimed at reducing spending, like UMTS.
3. Excludes the cyclical effect.
4. Total tax and non-tax current revenues plus capital revenues.
5. Includes all on-off measures (recorded as positive receipts) aimed at increasing revenues.
6. Current primary spending adjusted for the cycle. Deflated by the GDP deflator.
7. Includes all one-off measures aimed at reducing the deficit.
8. Excludes net interest payments. Includes all one-off measures aimed at reducing the deficit.
Source: OECD, Economic Outlook 76 database; Ministry of the Economy and Finance.

Given the high debt-to-GDP ratio, the priority for fiscal policy must be to reduce it substantially over the medium term. Much larger primary surpluses are necessary than those realised in recent years or projected by the OECD, and other debt-reducing measures should be undertaken. Although the latest medium-term fiscal plan (DPEF) postulates an improvement in the primary balance by some ½ per cent of GDP each year until 2008, it does not give precise indications as to how this is to be achieved, whereas Italy’s underlying primary spending has been rising faster than the means of financing it for many years now. A more detailed multi-year budgetary process is therefore desirable. One-off measures should be phased out completely by 2006 as planned, and be replaced by permanent cuts in structural spending programmes, preferably large enough to make room for subsequent growth-enhancing cuts in tax rates. When the output gap has been closed, Italy should further strengthen its consolidation efforts.

General government debt
Level and determinants of the changes
Per cent of GDP 

1. Net borrowing excluding net interest payments. A minus position means a primary surplus.
2. The self-reinforcing effect of public debt accumulation or decumulation arising from a positive or negative differential between the interest paid on public debt and the growth rate of nominal GDP.
3. Includes the accumulation of financial assets, change in the value of debt denominated in foreign currency and remaining statistical adjustments.
Source: OECD, Economic Outlook 76 database.

Should public spending and taxes be reformed?

Some spending cuts can be achieved by improving administrative efficiency: duplications of functions across different levels of government should be avoided while decentralising and the coming retirement of baby boomers should be used as an opportunity to achieve net reductions in staffing levels. Increases in public sector salaries should be limited to moderate rates, in order to be consistent with the new spending growth caps. Priority in spending should be given to improving infrastructure, especially in the south, and human capital. As in virtually all OECD countries, public spending on health is on an upward trend. Insofar as health services are a superior good and households are willing to spend more on them as their incomes rise, this need not be a problem in itself. But this should include a higher level of co-payments, continuing careful scrutiny of regional proposals and outturns, and more benchmarking across regions. Both spending control and efficient delivery are complicated by the fact that health spending is decentralised, yet financed essentially by the State, and wage levels are fixed at the central level. On the pension side, the recent reform is a major one though it is regrettable that it has been delayed to 2008. An updating of benefit coefficients to reflect increased longevity is due in 2005, and it should not be delayed. Further debt reduction measures should include stepped-up privatisations, including in network industries, to attain the € 100 billion target (about 7% of 2004 GDP) of the latest DPEF.

Pension expenditure to GDP up to 20501
National baseline scenario

1. The forecasts were made by the Regioneria Generale dello Stato pension model updated to 2003.
Source: Ministry of Finance, Technical Report to the Pension Reform (Law 243/2004).

Although Italy’s overall tax burden is not above average, including tax on personal incomes, the existence of a large-scale informal sector means that those who pay taxes face high average and marginal rates, which distort work effort and encourage informal working, exacerbated by the fact that the tax codes are complex, making compliance time-consuming. After a pause for most of the 1990s, amnesties were used extensively during the period of slow growth. These practices should be discontinued to avoid the risk of weakening tax compliance. The authorities have instituted a two-part cut in income tax rates, a first stage in 2003 for lower incomes and a second stage for mid to upper incomes, accompanied by simplifications, in 2005. On condition that the recent tax cut can be financed through permanent structural measures on the spending side, it is a welcome development. Moreover, it should be carefully designed so as to avoid excessive rises in marginal rates at low to medium income levels via tax allowance withdrawals. Tax amnesties should be definitively phased out and be replaced by more vigorous programmes to fight tax evasion across the economy.

 

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