I. Introduction and Overview

1. Achieving higher growth, especially through raising employment, was a central issue for the 2002 Article IV consultation with Italy, and this theme is touched on in each of the following chapters. The first provides an estimate of the output gap and potential output for Italy, and examines the sensitivity of the results to assumptions regarding employment and productivity growth. The second focuses on the labor market more directly by examining the linkages between wage bargaining systems, regional wage differentiation, and regional unemployment disparities. The third provides an assessment of the government’s tax reform program, including its potential to increase incentives for employment and investment. All three of these studies draw to on the experience of, and evidence from, other advanced economies, especially in Europe.

2. Chapter II presents updated production function estimates of potential output for Italy, which imply a lower output gap in 2001, but similar potential growth (of around 2 percent) going forward. The new output gap estimate for 2001 falls within the range of those of the EU Commission, the Italian authorities, and the OECD. The downward revision of the gap for 2001 (from -2 to -1 percent) follows largely from lower than earlier expected output growth from 1997–2001. Underlying this was a sharp decline in measured growth of total factor productivity (TFP)—larger than experienced elsewhere in Europe—accompanied by a sharp rise in employment, including of persons who were perhaps less productive than those in the existing workforce.

3. Looking forward, the projections point to potential growth rising only slightly over the next few years, in contrast to those of the OECD and the authorities which anticipate a more substantial increase. Underlying this modest rise is a moderation in the rate of employment growth (bringing it slowly back into line with its historical past), offset by a rebound in TFP growth (bringing it closer to that of large European countries). In contrast, the OECD and the authorities anticipate a much smaller decline in the rate of employment growth, and a slightly stronger rebound in TFP growth. However, as also argued by the OECD, maintaining such high rates of employment growth may require further substantial labor market liberalization. Moreover, the staff view that such employment growth may require employing less productive persons, thereby dampening productivity growth.

4. Chapter III picks up on the theme of employment by examining the link between regional wage differentiation and regional unemployment. It presents evidence that in comparison with other euro-area countries, Italy has very low regional wage differentiation, despite very high regional unemployment disparities; the gap between unemployment in the North and the South is currently about 15 percentage points. The study argues that Italy’s very centralized and coordinated wage bargaining system is one of the reasons for its low regional wage differentiation. Previous literature has argued that a centralized wage bargaining system, although it may facilitate moderate inflation, is often dominated by the leading region (in terms of productivity), causing uniform regional wages, and high unemployment in regions with lower productivity.

5. The empirical evidence presented suggests that regional wage differentials are likely to increase in Italy if a more decentralized wage bargaining system were adopted. According to these results, if Italy’s wage bargaining system were decentralized, regional wage differences would increase by more than 5 percentage points (ceteris paribus). This would bring Italy’s regional wage dispersion slightly below the euro area average, with the remaining difference explained by other wage determinants.

6. Chapter IV provides an account and assessment of the government’s tax reform program, embarked upon since coming to office in 2001. The program envisages both a substantial reduction in the overall tax burden, and far-reaching changes in the structure of the tax system. The chapter examines each of the major tax categories affected—namely those on labor, corporate, and capital incomes, together with the regional tax on value-added (IRAP)—and assesses the effects of the reform program on incentives to work and invest. The chapter notes that the program of tax reform now underway largely undoes the series of reforms introduced in the late 1990s by the previous government. These had been aimed at removing various tax distortions, including the bias in favor of debt finance, the lock-in problems of the capital gains tax, and the dependence of regional governments on a multitude of taxes with relatively narrow bases.

7. To some degree, the present reforms align the system closer to that in other EU countries, and address some shortcomings emerging under the previous system. The personal income tax was in clear need of further restructuring and simplification, and the introduction of consolidation provisions promises a useful rationalization of the taxation of businesses. The changes however, represent a fundamentally different approach to tax reform, focused less on neutrality—indeed the present reforms reintroduce a number of distortions—and more on simplification and, in particular, establishing a system closer to those found elsewhere in other large EU countries.