Italy: Toward a Growth-Friendly Fiscal Reform
Author: Michal Andrle1, Mr. Shafik Hebous, Mr. Alvar Kangur, Mr. Mehdi Raissi, and Rishi Goyal2
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Author’s E-Mail Address: mandrle@imf.org; shebous@imf.org; akangur@imf.org; mraissi@imf.org
Publication Date:
16 Mar 2018
ISBN:
9781484347584
Language:
English
Keywords:
WP; tax credit; internal rate of return; public spending; tax burden
Download PDF (901.5 KB)

Published in late 2017, the Italian medium-term fiscal plan aims to achieve structural balance by 2020, although concrete, high-quality measures to meet the target are yet to be specified. This paper seeks to contribute to the discussion by (i) assessing spending patterns to identify areas for savings; (ii) evaluating the pension system; (iii) analyzing the scope for revenue rebalancing; and (iv) putting forward a package of spending cuts and tax rebalancing that is growth friendly and inclusive, could have limited near-term output costs, and would achieve a notable reduction in public debt over the medium term. Such a package could help the authorities balance the need to bring down public debt and, thus, reduce vulnerabilities while supporting the economic recovery.

Abstract

Published in late 2017, the Italian medium-term fiscal plan aims to achieve structural balance by 2020, although concrete, high-quality measures to meet the target are yet to be specified. This paper seeks to contribute to the discussion by (i) assessing spending patterns to identify areas for savings; (ii) evaluating the pension system; (iii) analyzing the scope for revenue rebalancing; and (iv) putting forward a package of spending cuts and tax rebalancing that is growth friendly and inclusive, could have limited near-term output costs, and would achieve a notable reduction in public debt over the medium term. Such a package could help the authorities balance the need to bring down public debt and, thus, reduce vulnerabilities while supporting the economic recovery.

I. Introduction

The Italian fiscal plans published in late 2017 commit to achieving a balanced budget in the medium term. The Update to the Economic and Financial Document 2017 (DEF) as well as the 2018 Draft Budgetary Plan emphasize this commitment. The Update to the DEF, which lays out the policy intentions for the next three years, projects the headline deficit to decline from 2.1 percent of GDP in 2017 to 1.6 percent of GDP in 2018, 0.9 percent of GDP in 2019, and 0.2 percent of GDP in 2020. The related structural deficit, i.e., the deficit adjusting for the economic cycle, is expected to decline from about 1.3 percent of GDP in 2017 to 1 percent of GDP in 2018, 0.6 percent of GDP in 2019 and 0.2 percent of GDP in 2020. However, concrete plans to achieve these targets were not specified, beyond identifying broad areas, such as cuts to follow spending reviews, the fight against tax evasion, and rationalizing tax expenditures.

This paper identifies growth-friendly options for achieving fiscal balance and putting debt on a firm downward path. It is divided into four parts:

  • Public spending trend and composition. An analysis of spending over the past two decades reveals (i) in the decade following euro accession, spending grew faster than potential output, owing in large part to the rapid growth of pensions; (ii) since the global financial crisis, spending has been broadly controlled, mainly through a freeze on hiring and wages and cuts in capital spending. Pension spending though has continued to rise; (iii) despite the recent spending control, the pre-crisis spending excesses have not been reversed; and (iv) achieving sizable and durable expenditure savings may require lowering the large pension spending. Improving the efficiency of health spending, especially at the local level and in some geographical areas, is also warranted.

  • Pension system. Over half of current primary spending is social benefit spending, which is dominated by pension spending. At around 16 percent of GDP, pension spending in Italy is the second highest in the euro area after Greece. The authorities have legislated several reforms. However, before the full effect of these reforms is evident over the very long run, fiscal pressures are likely to persist and weigh on Italy’s goal of achieving and maintaining a balanced budget. The second part of this paper finds (i) despite past reforms, there remain generous parts of the system where Italy is a clear outlier, pointing to areas of potential savings; and (ii) pension projections rest on optimistic assumptions of (a) employment, specifically that Italy will go from having among the highest to very low unemployment rates; and (b) Italy will maintain much higher real GDP growth rates for decades to come than has been its experience and policy settings. Relaxing these assumptions implies a notable rise in projected spending over the coming decades until the full benefits of past reforms become evident.

  • Revenue rebalancing. The tax system is characterized by a high tax wedge, a relatively narrow tax base, and significant tax arrears. A fiscal devaluation strategy—a shift from taxing productive factors to taxing consumption and property—reveals the scope to (i) decrease the tax wedge significantly; (ii) reduce value-added tax gaps (both compliance and policy), by harmonizing the reduced VAT rates and improving the tax collection performance; (iii) rationalize tax expenditures; and (iv) raise revenues by re-introducing a modern property tax on primary residences.

  • Toward a growth-friendly policy mix. The last part of this note simulates, using the IMF’s Global Integrated Monetary and Fiscal (GIMF) model, the impact of a growth-friendly mix of spending and revenue measures along a gradual fiscal consolidation path that puts Italy’s debt-to-GDP ratio on a firm downward trajectory. The model simulations show that a revenue-neutral and less distortionary tax reform, alongside current spending cuts and capital spending increases, can generate sizable output gains and a sustainably lower public debt ratio over the medium to long term. Short-term output costs of this fiscal package, if implemented credibly, are limited.

II. Public Spending Trends and Composition

Over the past two decades, primary spending in Italy has grown faster than potential output. This was particularly the case in the years after euro accession. From 1999 to 2007, Italy’s nominal current primary expenditure grew faster than the euro area average, and well above the country’s average nominal potential growth—driven mainly by social benefit spending (primarily pensions), intermediate consumption (goods and services), and wages (in general services, defense and health). Capital spending rose in line with that of the euro area average. From 2008 to 2016, however, Italy’s nominal current primary expenditure grew at 1.8 percent per year on average, below the euro area average of 2.6 percent.2 The deceleration after the global financial crisis was driven mainly by the decline in the public sector wage bill—reflecting the freezing of nominal wages from 2010 to 2015 and a reduction in the number of public sector employees from 3.6 million in 2007 to around 3.3 million people in 2015; and a severe cut in capital expenditure, which declined by about 28 percent in nominal terms between 2009 and 2016. Nevertheless, even with these exceptional measures, total primary spending grew above the country’s average nominal potential GDP growth over this period. Italy has been unable to reverse its past overspending (especially those related to the pre-crisis period).

uA01fig01

Nominal Primary Expenditure

(1996=100)

Citation: IMF Working Papers 2018, 059; 10.5089/9781484347584.001.A001

Source: Eurostat.
uA01fig02

Primary Spending

(Percent of potential GDP, 1996=100)

Citation: IMF Working Papers 2018, 059; 10.5089/9781484347584.001.A001

Source: Eurostat.

Rising social benefits have dominated public spending. Social benefits have dominated all other categories of spending, rising by about 43 percent cumulatively from 1999 to 2007 and by a further 33 percent since then. It constitutes half of total primary spending, up from 40 percent at the time of euro accession. The bulk of social benefits spending is in pensions (see next section), reflecting both a high share of elderly population and generous pension benefits with high replacement rates. However, non-pension social benefit spending in Italy is low, fragmented, and poorly targeted in comparison to other EU countries. The latter is evidenced in the disproportionately low share of social transfers accruing to the low-income working age population (Box 1). There is also a higher reliance on intra-family transfers for social assistance, even as there is underspending related to social inclusion, family/child benefits, and housing relative to the euro area average. Reducing the fragmentation of anti-poverty programs and improving their targeting are therefore warranted.

Poverty Reduction Measures

Designing and implementing poverty-reduction policies has largely been delegated to local governments, with nationwide programs tailored mostly toward the elderly and people with disabilities. This has left a large share of the population, especially the young and children, weakly protected. One of the early efforts to tackle poverty has been the Minimum Insertion Income which was introduced in 1999 on an experimental basis. As an emergency measure to provide limited support to low-income families affected by the financial crisis, the government introduced a social card in 2008, which was subsequently re-designed and broadened in scope in 2011 to provide a mix of cash transfers and social services.

The government launched the SAI (Support for Active Inclusion) program in 2013, targeting low-income families with children/disabilities and in a limited number of municipalities. With the 2016 Stability Law, Italy set up, for the first time, a Fund for Combating Poverty and Social Exclusion with the aim of introducing a minimum-income program at the national level by 2018. In the meantime, the SAI program was extended nationwide in 2016 and its eligibility requirements were relaxed in 2017.

The SIA program and other pre-existing income support measures will be replaced, as of January 2018, by a new program called Inclusion Income (Reddito di inserimento, REI)—introduced within an enabling law in 2017, which is expected to increase the number of households receiving help (from 160,000 households in SIA to 660,000 households in REI). Benefits are given to those households with children under 18 years old, pregnant women, and unemployed people above 65 years of age that are experiencing economic hardship (an equivalent financial situation index of €6,000 or less, per a top-up formula), and based on a comprehensive evaluation of need that considers both income and wealth. Benefits are conditional on a personal plan of work, and social inclusion prepared by local administrations: the applicant must participate in a personalized work/social program that could encompass any civic service—from the municipalities to employment centers, from schools to healthcare services—with the involvement of the services sector. The REI program, once fully operational, will have annual funding of about €1.8 billion. Apart from tackling poverty, the program aims to re-organize welfare services and improve coordination among social services.

Figure 1.
Figure 1.

Italy: Social Benefits

Citation: IMF Working Papers 2018, 059; 10.5089/9781484347584.001.A001

Source: Eurostat, Haver, OECD, and IMF staff.

There are other areas of overspending relative to the euro area average. Although much has already been written about the subject in Italy (Box 2), a decomposition of spending—using standard economic and functional classifications at the general and local government levels (Tables 1–4)—reveals some essential points:

  • As noted above, social benefits spending (see the social protection column in Table 1) is the area of largest overspending relative to the euro area average. Interest payments exceed the euro area average by 1.6 percent of GDP, given Italy’s high stock of public debt.

  • Other areas of overspending include intermediate consumption spending (primarily on goods and services) in the health sector; compensation of employees in defense, public order and safety, and health; subsidies in the economic affairs sector; and capital transfers in general services and economic affairs.

  • It is notable that although overall public health spending in Italy is in line with the euro area average, the bulk of it is for compensation of employees and intermediate consumption, in contrast with the euro area average. This points to room for potential efficiency savings, at the local-government level.3 Medeiros and Schwierz (2015) highlight regional differences and show that the output of public spending is lower in southern regions based on health-related variables, such as life expectancy at the age of 65.

  • The main areas where Italy underspends is in education (i.e., in the provision of goods and services and in total compensation). The public education expenditure gap is especially concentrated at the tertiary level, as highlighted in OECD (2015). As for economic classification, underspending is in gross capital formation.

Table 1.

Italy and Euro Area: General Government Spending, 2005–2014, and 2015

(Percent of GDP)

article image
Table 2.

Italy and Euro Area: Local Government Spending, 2005–2014, and 2015

(Percent of GDP)

article image
Table 3.

Italy and Euro Area: General Government Spending, 2005–2014, and 2015

(Percent of GDP)

article image
Table 4.

Italy and Euro Area: Local Government Spending, 2005–2014, and 2015

(Percent of GDP)

article image

There is room to improve the spending mix to make it more growth friendly and inclusive. The above simple presentation indicates that rising social spending (primarily pensions) has crowded out spending in areas such as education and capital spending. Achieving a more growth-friendly and inclusive spending policy mix, while making space to achieve the medium-term objective, will likely require rationalizing total social benefit spending; improved targeting of non-pension social benefit spending to those who need the resources most; better efficiency in health spending at the local level; and reallocation of spending toward capital spending and education, while also improving the efficiency of outcomes in both areas. Protection of the vulnerable could be further improved through complementary measures such as more intense use of active labor market policies and a modern social safety net.

Spending Reviews

Recent governments conducted comprehensive Spending Reviews with the aim of finding cost-efficient ways to cut spending.

The first plan was presented in April 2012—the so-called “Giarda spending review report”—with a focus on (i) large territorial differences in the production costs of public services across all sectors and government levels; and (ii) very diverse territorial scope of the entities to which the same administrative functions are assigned, thereby leading to inefficiencies and high variability of unit costs because of scale economies. The report proposed different pathways for expenditure rationalization, from more radical reforms such as privatizing public services on efficiency grounds to more targeted actions aimed at enhancing public spending efficiency.

A second major spending review was conducted by Carlo Cottarelli with a plan to achieve savings worth up to 0.4 percent of GDP in 2014, 1 percent of GDP in 2015, and 2 percent of GDP in 2016 compared to a trend scenario based on unchanged legislation. The so-called “Cottarelli spending review report,” made public in March 2015, analyzed a broad range of spending items and proposed priority actions to rationalize spending, including (i) more centralized public procurement, including in healthcare; (ii) streamlining and digitizing of all public administrations; (iii) cuts in the number of state-owned enterprises, particularly at the local level; (iv) reduction in specific forms of public support to firms; (v) rationalization in the provision of certain public services; and (vi) interventions on pension entitlements, including de-indexation.

In 2016, the reform of the accounting law envisaged the integration of the spending review into the economic-financial planning cycle.

Following sharp cuts in capital spending and with the wage bill/GDP at its lowest in two decades, rationalizing social benefits spending appears unavoidable. In recent years, the authorities have pursued a strategy of notably cutting capital spending and curtailing the wage bill, which at 9.8 percent of GDP is at its lowest level in several years. This strategy may be close to its limit, however, and may be neither sustainable nor desirable. There is a need for public investment to support stronger, sustained growth.4 Moreover, as a share of total employment, public sector employment is below the euro area average; the age structure of public employees is titled toward older workers, implying the need to refresh the skill mix without reducing the headcount further (there have been recent announcements for hiring sizable numbers of new staff, in education and local offices); and, after years of wage freezes, wage increases are planned.5 This suggests limited room, if any, for further cuts in the overall wage bill or in capital spending, going forward, and thus for little alternative but to tackle the sizable social benefits spending.