Statement by Pier Carlo Padoan, Executive Director for Italy

Italy has made impressive strides in achieving deep-rooted macroeconomic stability. But growth has disappointed over the past decade. The government has laid out a bold agenda to reinvigorate growth. Specifics of an expenditure and tax reform agenda should be laid out early. A key to achieving more dynamic growth is to tackle the root causes of Italy's large regional imbalances and labor market weakness. Although the liberalization of product markets has been advancing, major scope remains to promote competition and efficiency.

Abstract

Italy has made impressive strides in achieving deep-rooted macroeconomic stability. But growth has disappointed over the past decade. The government has laid out a bold agenda to reinvigorate growth. Specifics of an expenditure and tax reform agenda should be laid out early. A key to achieving more dynamic growth is to tackle the root causes of Italy's large regional imbalances and labor market weakness. Although the liberalization of product markets has been advancing, major scope remains to promote competition and efficiency.

The challenge ahead: stability, growth, and equity

1. At the outset I would like to thank staff for their extremely useful work during this consultation. They have provided an insightful analysis and laid out the framework for the policy choices the government is making at the beginning of its mandate. Over the past five years Italy has achieved financial and price stabilization. With a clear mandate to govern the country for a full legislature, the challenge ahead for the newly elected coalition is to preserve financial stability; increase the potential for output and employment growth, especially in the Southern regions; and ameliorate the distribution of income, within and across generations, in ways consistent with incentives to growth. These objectives will be achieved by complying with the EU fiscal rules; streamlining the role of the state in the economy; developing infrastructure, technology, and human capital; reforming the labor and products markets; and reducing taxes.

A necessary precondition: fiscal discipline

2. The government has reaffirmed Italy’s commitment to the process of economic adjustment agreed upon with EU partners. The respect of the fiscal guidelines set by the Stability and Growth Pact (SGP) remains the pillar of Italy’s macroeconomic policy. As much as they inform the government’s short-term action, the guidelines also underpin the medium-term strategy and define the financial compatibilities within which trade-offs will be evaluated and choices made. The reform programs that will be implemented during the legislature and the associated expenditure plans will thus be conditional on the compliance with the SGP targets.

The short-term outlook

3. The September 11 events have led to major downward revisions of the growth perspectives for 2001 and 2002, much in line with revisions for other EU countries Revised staff estimates indicate lower growth for 2001 and, especially, for 2002, for which projected growth is below 1.5. What is worrying about such a scenario is not so much the downward revision but, especially, the deceleration of growth in 2002 that, according to staff estimates, is entirely due to a strong deceleration in exports, leading to a negative contribution of the foreign sector. This effect is somehow surprising given that in the past Italy has been exposed less than other major EU countries to negative shocks from the industrialized area and that the “new” transmission mechanisms through expectations and financial channels are also less powerful. On the contrary, all other demand components are seen to be on the rise. Given the still very high degree of uncertainty surrounding the current situation my authorities maintain that growth estimates for 2002 remain on the rise (see the update to DPEF, “Nota di Aggiornamento,” issued on October 29) and wait to evaluate the consequences of September 11.

4. Abstracting from this component, some of the factors responsible for the slowdown beginning in the second half of 2000, such as higher oil prices, were beginning to change direction in the second half of the current year, while export shares were reverting a long declining trend. Assuming the projected acceleration of machinery and construction investment in 2002, as well as continuing wage moderation that will preserve competitiveness, a pick-up of growth next year could still represent a plausible hypothesis. Recent data are, in this respect, somewhat encouraging.

5. While it is true that business confidence indicators have dropped, they also reflect the fact that firms have chosen to “wait and see” from the perspective of the new fiscal measures, in particular the major tax reform package due by the year end. More recent surveys indicate that manufacturing firms see the situation as “uncertain,” but they also see signs of moderate optimism. Recently released consumer confidence indicators indicate no substantial change in households’ attitude after the September events.

6. VAT revenues in October increased by 2 percent with respect to October 2000. Social security contributions rose 6 percent over the same period, pointing at substantial employment increases on top of an already significant employment growth. It would be surprising if this were not associated with better output performance.

7. That said, 2002 will see lower growth, in Italy as almost everywhere, with respect to previous forecasts. Lower growth will bring a lower speed in the implementation of reforms. Nonetheless, the budget will generate in 2002 changes in the right direction as the primary surplus will increase, interest payments will decrease, and the overall balance will meet the 0.5 target. These results are expected by the government, assuming very conservative estimates for the revenues from “emersione” of the underground economy and from capital repatriation measures.

The longer-term trade-offs

8. The Staff Report contains a very useful discussion of the long run trade-offs for fiscal policy. The comparison between the baseline, the “tax cuts/no entitlement reforms,” and the “reform” scenarios confirm what one might have suspected about the long-run preferability of reforms. The scenario exercises are clearly illustrative but, by providing benchmarks, they do help, together with the discussion in the text, to clarify the options that the government is facing in the medium term.

9. As for all simulations, the scenarios rely on specific assumptions that may lead to different pictures once they are changed. One factor to which these exercises are highly sensitive is the projected rate of growth. As Box 1 recognizes different assumptions on growth (as adopted for instance in studies by the Treasury in the framework of an OECD exercise) would lead to different results in terms of pension sustainability. So, to make these exercises more useful, one should try to incorporate the feedback on growth of the announcement and implementation of reforms; and the effect on growth of related measures such as, for example, those aimed at supporting employment.

10. This said, the report does provide a clear analysis of the trade-offs the government is facing. The definition of the medium-term strategy is currently under way. The following points, however, can already be set out.

  • Raising the growth rate significantly and permanently and the employment content of growth remains at the center of the medium-term strategy.

  • The budget will balance by 2003 and will move into surplus in 2005 at the latest, leading, according to Treasury calculations, to an improvement of the structural balance.

  • While keeping to its fiscal commitments, the government, starting in 2003, will reduce the overall fiscal pressure by bringing it down from 41.5 percent in 2003 to 38.2 percent in 2006. The tax rate structure will be simplified, and the highest tax rates on personal and corporate incomes will be reduced significantly.

  • Expenditures will be put under strict control starting from 2001, and will decline by 4 percentage points over 2002-06.

  • The fiscal burden will be redistributed in a more equitable way by introducing exemptions for larger families and for lower-income groups. Social security contributions will be reduced, and minimum pensions will be raised from 2002 onward, starting with the elder and more vulnerable beneficiaries.

11. The current slowdown requires postponing by one year the implementation of a new fiscal reform in addition to the temporary measures introduced by the 2002 budget. The implementation of key reforms in pensions and the labor market will start after consultation with the social partners, which has recently begun, is completed. This consensus building exercise will provide the credibility for the reform process and generate positive externalities on other measures, such as those related to the emersion of the underground economy, by providing credibility to the tax-cut plans. Finally, important results have already been achieved in health expenditure control following recent agreement with the regions.

Boosting growth potential and narrowing the regional gap

12. Raising Italy’s low rate of growth as well as its employment content is key in the government’s medium-term strategy. As mentioned in this Chair’s BUFF in 2000, low growth is to blame on high taxes on labor and a generally high tax burden, and on other factors as well, such as a limited contribution of total factor productivity due to both a relatively low propensity to innovate (as measured by standard innovation indicators) and to lacking infrastructure. In addition, the low growth performance for the economy as a whole clearly reflects the performance gap between North and South.

13. Italy’s disappointing growth rate would significantly be lifted by the catching-up of the Southern regions to higher Northern values. Evidence for the late 1990s suggests that catching-up has already begun. The latest available data show that, between 1997 and 1999, the Mezzogiorno has grown faster than the rest of the country (2.7 percent versus 1.8 in 1997, 2.1 percent versus 1.7 in 1998, 1.8 percent versus 1.6 in 1999). This calls for growth-boosting measures that are targeted at both national and regional dimensions. Labor tax cuts, measures to encourage entry of youth and women in the workforce, as well as continuing wage moderation, will benefit the whole economy. Measures for the “emersione” as well as wage-setting mechanisms that better reflect differences in productivity will sustain growth and employment in the lagging regions. The White Book (“Libro Bianco”) on employment and social issues, recently released by the government, represents a promising base to set out the strategy both at the national and the regional level.

A smaller state, a more efficient state

14. A smaller and more efficient public administration supports growth potential both by decreasing pressure on domestic resources and by helping markets work better. Moves to achieve this target include measures in the 2002 budget towards the containment of public expenditure through enrollment freeze, employment reductions, and improvements of cost-controls and procurement rules; the suppression of redundant state agencies and the transformation of others into non-profit private sector companies; the divestiture of large chunks of state-owned real estate assets; and the reorganization of public services provision through decentralization, wider office-automation, and outsourcing to the private sector. Strong emphasis is placed on the simplification of administrative and procedural requirements on enterprises, building on initiatives undertaken in the late 1990s, and on the adoption of an up-to-date information infrastructure to better link public administration and the private sector.

15. Privatizations in the energy, transportation, and telecommunication sectors, for a total of euro 60 billion worth of assets over the legislature will add to the process of state retrenchment from the economy. Privatization of the main electricity company will be accelerated provided that market conditions are appropriate.

16. The government will further the process of fiscal devolution that Italy initiated in the early 1990s, both on grounds of economic efficiency and in response to demands for regional decentralization of fiscal responsibilities. Local administrations have been granted higher spending and taxation authority, as well as larger entitlements to national fiscal revenues, with a view both to connecting more closely the provision of local services to the needs of local users and to linking spending decisions and financing responsibilities more tightly. The implementation and the strengthening of the Internal Stability Pact will exert discipline on local administrators by requiring them to correct excess deficits with spending cuts, tax increases, or new borrowing.

Improving infrastructure, deepening technology, expanding knowledge

17. A smaller state will make room for a more effective public action on infrastructure development. The “Legge Obiettivo” takes into account that considerable investment is needed in the hydro-geologic, water, and transportation systems, with large works to be undertaken especially in the South and in the other laggard areas. Financing will be made available from budget savings and from private sector resources through project financing.

18. The government intends to increase in the medium term the public R&D expenditure-to-GDP ratio to match the level prevailing in the rest of the EU, adopting transparent and merit-based criteria for allocating public resources. Great importance is given to the creation of a new patenting system, which will better protect the intellectual property rights of innovators. This, combined with venture capital money, is expected to spur research initiatives.

19. On information and telecommunications, the government will launch a five-vear plan to develop a cross-country, wide-band system for the expansion of internet; it will support the full liberalization of telecommunication services, and will implement a program to expand the use of IT in the public administration and in schools.

20. Education ranks high on the government’s list of priorities. As the limits on public sector enrollment and employment will extend to the school system, spending will be redirected from wages to teacher training programs and the diffusion of multimedia technologies in classrooms. Overall, the state will compete with the private sector in carrying out direct school managerial responsibilities, while it will define overall education policies and quality standards. The reform will also improve the supply of higher education services.

Making labor markets more efficient

21. As mentioned, the “Libro Bianco” lays out the basic principles for improving employment performance. The government plans to raise the employment rate to 59 percent by 2006 (from 53 percent in 2000). Such a target is to be interpreted as a first step in the framework of the Lisbon strategy, the target of which, for the EU as a whole, is 70 percent in 2010. Both measures that favor economic growth prospects, particularly in the South, and measures aimed at increasing the employment intensity of growth and favoring employment prospects of youths, women and elderly people are envisaged. Measures will concentrate upon further easing the use of part-time and “atypical” contracts to facilitate market entry, especially for the young and for women. In doing that, attention will be paid to the existing set of regulations so as to avoid the risk of labor market segmentation between atypical and typical. Rules and controls will be simplified for private job-market intermediaries, while aiming at market transparency through the set-up of an interconnected information system (“Sistema Informativo del Lavoro”) on supply and demand.

22. Employment incentives will be simplified and better targeted. Under these respects, the Libro Bianco further hints at the possibility of experimenting with in-work benefits for low-income people, so as to allow also for a wider wage differentiation and incentives to the female labor supply. A gradual shift is also envisaged from the traditional rather strict on-the-job protection system, benefiting insiders, to more efficient in-the-market guarantees for all workers, through a better integrated design of active and passive labor market policies. The timing of such a shift is connected to the actual prospects of pensions’ expenditure, the dimension of which still limits the room for social contributions cuts and/or redirections.

23. Finally, wage setting mechanisms should be improved to take into account the productivity differential. This should significantly reduce the employment differential between North and South. The unemployment rate, which has decreased one percentage point to 9.4 in July 2001 with respect to the same month in 2000 for the country as a whole, amounted to 3.9 percent in the North and 19.1 percent in the Mezzogiorno.

Expenditures: declining amounts, better quality

24. The medium-run target for expenditure decline affects all the main items: public sector employment, health and pensions. With regard to public sector employment, the government’s principles of streamlining and raising the efficiency of public administration are embodied in the 2002 budget. In this regard, strict limits will be imposed to public sector hiring, that will be de facto frozen in 2002, and will lead to a decline by at least 1 percent of the workforce in 2003 and 2004. Furthermore, public procurement will be centralized and rationalized.

25. Health expenditure, which makes up for the largest share of the expenditure at the decentralized levels of government, will be contained thanks to a recent agreement with the regions, which complements in an essential way the devolution reforms of the previous years. The agreement, which covers the entirety of the financial relations between the state and local governments, sets a guideline of a 4.5 percent nominal growth in 2002 expenditures of the regions. The increase in transfers to regions acknowledges the systematic ex ante underfunding of health expenditures by the central government. At the same time, the regions’ entitlement to the transfers from the central government is made conditional on their systematic reporting and monitoring of expenditures, their participation in a centralized procurement system, and their provision of minimum levels of health care defined on a national basis. Most importantly, the centerpiece of the agreement is represented by the principle of accountability for expenditure overshooting compared to the predetermined targets. Local administrations will be solely responsible for their financing through increases in local taxes, expenditure cuts, or borrowing.

26. The government is currently considering a review of the pension system through the build-up of support of social partners, including trade unions and business associations. The results of a report by a commission appointed by the Ministry of Labor (“Commissione Brambilla”) confirm the need for reform. In the absence of corrective measures, the report projects pension expenditures as an increasing share of national GDP in the coming years at least through 2030, when they will reach 16 percent. Indeed, the present set up suffers serious weaknesses, in particular in the relatively slow phasing in of the contribution-based system, the still very low average retirement age, and the limited role of private pension plans. The government is committed to a reform of the system, relying on the principles of safeguard of existing entitlements and freedom of choice of private or public pension plan. The reform process will however be delicate, due to the extensive social stakes in play. It is worth noting that the government, in the 2002 budget, has increased the level of minimum pensions for seniors to around 500 euros per month. This amount constitutes the only increase in expenditures in terms of GDP in the area of pensions in the budget.

27. Capital expenditure accelerated in 2001 compared to 2000, and will further increase in 2002 and the following years. Public investment will be concentrated in infrastructures, especially in the South. As mentioned, this program will rely extensively on private sector participation through project financing, which will amount to half the financial resources needed for the ambitious investment plan. The importance given to this area of action is underlined by the layout of a framework law for public investments as part of the initiatives for the “first 100 days” of the government.

Reducing and simplifying the tax burden

28. A comprehensive tax reform proposal will be presented by year-end with the aim of reducing fiscal pressure slightly in 2002 and at an accelerating pace starting in 2003. To this end, the government envisages the reduction in the number of taxes from the current one hundred to only eight. In the same vein, the more than three thousand fiscal norms will be rationalized into one comprehensive fiscal code.

29. The new “Tremonti Law” has introduced incentives for investment decisions while simplifying the procedures. With respect to similar measures adopted in 1994 it has widened the range of eligible beneficiaries including -- in addition to manufacturing firms -- banks, insurance companies and the self-employed. It has also widened the range of investments falling under the new scheme, comprising investments in fixed capital as well as in human capital. Such measures, which were introduced last July, are expected to be in place until December 2002. In addition the government has reintroduced the norm allowing for the revaluation of assets for firms (introduced in 2000) and has extended it to other items such as land property.

30. The authorities see these measures as temporary. They envisage a far-reaching reform on business taxation bringing down the rates on corporate incomes to 33 percent from the current 36 percent, while at the same time simplifying and making more effective the related procedures for tax compliance while affecting permanently the cost of capital.

31. On personal income taxation, the authorities plan to reduce and simplify the current framework, by adopting only two tax rates, namely 23 percent on incomes up to around euro 100,000 and 33 percent for incomes above this amount.

32. As noted, the tax wedge in Italy ranks high with respect to other OECD countries and reduces the hiring incentives for firms while discouraging workers to actively seek a job or even to enter the labor force. To this purpose, the government plans to reduce the wedge by decreasing social security contributions by roughly one percentage point per year over the next five years.

Conclusions

33. At the conclusion of last year’s Art. IV discussion this chair pointed out that sound macroeconomic policies and structural reforms were beginning to bear fruits and that pressing ahead with the reform agenda was essential. The global slowdown, precipitated by the September 11 events, has certainly made the environment for reforms more difficult in Italy, an environment where business expectations were pointing at an upcoming acceleration of growth above what was expected in other major EU countries. Notwithstanding the current uncertainty, my authorities remain strongly committed to push ahead with their ambitious, yet indispensable, program, as they believe that credible reform plans will provide a positive shock on confidence that will push the economy away from the risk of falling into an “expectation trap.”