This paper focuses on selected aspects of Italy’s fiscal situation, its origins, and its pervasive economic consequences. The paper analyzes different aspects of regional duality and the unbalanced recovery. The paper highlights that regional duality is a salient feature of the Italian economy. In the south, average incomes and consumption are lower, unemployment rates higher, and the percentage of the population living in poverty larger than in the center and north. The paper also examines fiscal performance of Italy during 1986–95.

Abstract

This paper focuses on selected aspects of Italy’s fiscal situation, its origins, and its pervasive economic consequences. The paper analyzes different aspects of regional duality and the unbalanced recovery. The paper highlights that regional duality is a salient feature of the Italian economy. In the south, average incomes and consumption are lower, unemployment rates higher, and the percentage of the population living in poverty larger than in the center and north. The paper also examines fiscal performance of Italy during 1986–95.

I. Introduction and Overview

The Italian economy in 1995 experienced a strong recovery set against weak domestic confidence and volatile financial markets. Fiscal issues continue to occupy a prominent place in the policy background, with some serious achievements that nonetheless failed to quell anxieties that fiscal adjustment might not be sustained. This background paper focuses on selected aspects of Italy’s fiscal situation, its origins, and its pervasive economic consequences.

Anxieties over fiscal sustainability have had a continuing, important influence on financial markets, accounting to a considerable extent for the chronic weakness of the lira and the wide spreads of Italian interest rates. The weak lira, in turn, fostered an unbalanced economic recovery: exports grew very rapidly while domestic demand remained sluggish, reflecting weak confidence and fiscal retrenchment. This macroeconomic pattern, in light of interregional differences in economic structure, exacerbated existing economic disparities between Center-North and South. This poses the risk that growth will spill over into inflation at an earlier stage than usual--and thus, that the undervaluation of the lira may be corrected through inflation rather than through a nominal appreciation, as would be desirable. In addition, there is the risk of worsening unemployment for a given growth performance, thus undermining support for the fiscal adjustment. The origins and consequences of the regionally unbalanced recovery are discussed in Chapter II of this paper.

Italy’s fiscal policy registered some important favorable developments in 1995: for the first time in several years, the debt-to-GDP ratio declined; the deficit was reduced markedly, with substantial cuts in primary expenditure; the overall fiscal balance out performed budget targets; and the government’s three-year fiscal plan improved on the previous one, breaking a pattern of repeated relaxation. These developments, if consolidated and pursued further, could mark a major turning point in the direction of sound public finances. Only some of what has been achieved is the result of new fiscal effort that will have a lasting effect, though, it also reflects the predictable effects of stronger growth and higher inflation, as well as the one-off measures (such as amnesties, temporary taxes, and changes in the timing of receipts and payments) that have dotted Italy’s fiscal landscape in recent years. An assessment of how much has really been done, an essential starting point for discussion of future measures, is presented in Chapter III.

To secure confidence in the sustainability of the fiscal effort, it is essential to make structural changes in entitlement programs. A key area of reform in Italy was pensions: the government undertook a major reform that established sound principles for the pension system, consistent with its solvency in the long run. At the same time, it left untouched the excessively generous benefits for workers with over 18 years of service, and left for the future the task of remedying the imbalances that the system will face with the demographic transition anticipated over the next several decades. The details of the pension reform and its implications in the long run steady state--as well as through the demographic transition and during the phasing-in period are discussed in Chapter IV.

At a more fundamental level, proposals have been discussed to reform Italy’s budgetary process in order to attenuate its perceived bias toward deficits. This would require changes in the formulation of the budget within the government, its parliamentary passage, and its implementation, along with increased transparency of budgetary concepts and documents. Reforms could involve constitutional rules for fiscal outcomes--such as a ceiling on the overall deficit--or they could involve changes in the “rule of the game” by which budgets are determined--in particular, to centralize responsibility for budgetary decisions. The reform proposals now on the table are evaluated in Chapter V; a key conclusion is that any rules for fiscal outcomes would, at the least, need to go hand in hand with fundamental changes at all stages of the budget process and in the transparency of budget procedures.

Italy’s existing fiscal imbalances, with their legacy of a larger public debt, may have profound ramifications for other areas of economic policy. In particular, it has been argued that with a high public debt-to-GDP ratio, a change in the stance of monetary policy can have an impact on the debt dynamics that may frustrate the central bank in its pursuit of price stability. The extreme form of this argument is the “unpleasant monetarist arithmetic” advanced by Sargent and Wallace: the perverse case in which a monetary tightening worsens the debt dynamics so much that its overall effect is inflationary. If this case were relevant, monetary policy could not pursue price stability independently of fiscal adjustment; coordination of monetary and fiscal policy would be not merely desirable, but a sine qua non for disinflation. Chapter VI examines empirical evidence on the relevance of this hypothesis for Italy and Ireland.

Italy: Background Economic Issues
Author: International Monetary Fund