Italy: Staff Report for the 2010 Article IV Consultation

The global crisis had a severe impact on the Italian economy despite elements of strength such as high private savings, low private indebtedness, and a resilient financial system. Executive Directors decided that the public sector wage bill should remain a key element of the consolidation strategy, and close monitoring of subnational public finances should be continued. They commended the authorities for the progress made in structural reforms but stressed that a more ambitious program of reforms needed to be pursued to address Italy’s growth potential.

Abstract

The global crisis had a severe impact on the Italian economy despite elements of strength such as high private savings, low private indebtedness, and a resilient financial system. Executive Directors decided that the public sector wage bill should remain a key element of the consolidation strategy, and close monitoring of subnational public finances should be continued. They commended the authorities for the progress made in structural reforms but stressed that a more ambitious program of reforms needed to be pursued to address Italy’s growth potential.

Analytical Annex I: Italy’s Fiscal Sustainability Revisited1

Despite unfavorable demographic trends, high public debt, and generous pensions, Italy’s longer-term fiscal outlook appears to be benign compared to euro area peers. This outlook, however, is not without challenges and risks. Ensuring fiscal sustainability would require economic growth much stronger than in the past decade, bold fiscal adjustment over the medium term, and full implementation of the planned pension reform as well as further reforms to improve intergenerational equity.

I. Introduction

Fiscal sustainability will be largely driven by demographic trends. The old-age dependency ratio is projected to double in EU countries in 2010–2060: for every person over 65 there will be only two working-age persons instead of the current four (the balance between inactive elderly and the employed population is even less favorable). Ageing is projected to affect both economic growth and public expenditure. Its impact, combined with post-crisis weak budgetary position, makes the long-term fiscal situation in Europe unsustainable in the absence of reforms (EC, 2009a). With unchanged policies, average EU public debt would be more than 400 percent of GDP in 2060, with about half of the required adjustment to ensure sustainability just offsetting the impact of ageing costs.

uA02fig01
Sources: Eurostat; and 2009 Ageing Report.

In Italy, the increase in age-related expenditures appears to be relatively contained, primarily owing to the expected impact of pension reforms already enacted. Between 2007 and 2060, total age-related government expenditure is projected to increase by about 5 percentage points of GDP for the EU, but only by 1.6 percentage points of GDP for Italy—the lowest among the advanced EU countries (Appendix Table 1A).2 At about 170 percent of GDP, the net present value of the projected increase in age-related spending in Italy is the second lowest after Japan, against an average of nearly 270 percent of GDP for advanced G-20 countries.3

uA02fig02
Sources: 2009 Ageing Report; and 2009 Sustainability Report, European Commission.

Consequently, Italy fares relatively well in terms of the standard indicators of fiscal sustainability. The authorities’ January 2010 Stability Programme Update projects a steady decline in the public debt ratio to below 40 percent of GDP by 2060 and an absence of sustainability gaps based on the standard indicators (for details on the latter, see EC, 2006). The 2009 Sustainability Report by the European Commission suggests that sustainability gaps exist in Italy, but these are the smallest in the euro area (EC, 2009a). Even with some upward adjustments to age-related costs, Balassone and others (2010) find that Italy would achieve the lowest debt and deficit ratios in 2060 and with smallest sustainability gaps.

This Annex examines the factors behind the relatively favorable long-term fiscal prospects for Italy. It identifies the factors driving the positive long-term outlook, particularly pension reform. It assesses the challenges and risks surrounding these outcomes, including the risk of reversal of the reforms and the weight of the adjustment put in future generations of workers. Finally, it discusses alternative illustrative scenarios and provides suggestions to ensure fiscal sustainability.

II. Current Fiscal Environment and Pension Reforms

A. The State of Public Finances in Italy

The financial crisis worsened Italy’s already fragile fiscal position and exacerbated the structural weaknesses of the budget. Public debt reached 115.8 percent of GDP in 2009—second only to Japan among advanced G–20 countries. The deficit doubled, despite modest stimulus measures and large one-off revenue receipts. Recent efforts to introduce more flexibility in the budget have helped ease slightly expenditure rigidities but the share of non-discretionary primary spending in GDP increased substantially, reaching 30½ percent of GDP in 2009.4 The high tax burden, including relatively high taxes on wages, and persistent problems with improving significantly the revenue-raising potential further constrain the fiscal policy space.

Pension expenditure is relatively large but its growth rate has stabilized since 2000.5 With one-third of budgetary resources spent on pensions, Italy has the largest share of pension expenditure in GDP among advanced economies. In addition to demographic factors—one inactive person over 65 for every two employed 15–64—the high level of pension spending reflects the relative generosity of the system. After several reforms, however, the growth rate of real pension spending has stabilized at below 1½ percent per year.

uA02fig04

Public Pension Expenditure, 1990-2008

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Source: ISTAT.
uA02fig05

ITA (14.0)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Sources: Country authorities; European Commission; OECD (2009); and IMF staff estimates.

Other age-related expenditures, especially health spending, have been on the rise and also show greater volatility. At about 7 percent of GDP, the level of public health spending is near the euro area average. The decentralized nature of health services involves risks, especially in the presence of “soft” budget constraints and negotiations of the health budget (Patto per la salute) between the central and subnational governments (the latter provide about 1/3 of total contributions to the health system).6 Ongoing fiscal federalism reform compounds the uncertainty in this area.

uA02fig06

Health Expenditure, 1990-2008

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Source: ISTAT.

B. Pension reforms in Italy

In many ways, the structure of the Italian pension system is broadly in line with pension systems in other advanced G-20 countries. These systems generally offer a means-tested pension benefit as the basic layer of retirement income accompanied by an earnings-related mandatory component and voluntary occupational schemes (Appendix Table A2). Nearly all of these systems index pensions to prices. Although Italy uses Notional Defined Contribution Accounts—which directly link contributions to benefits—instead of the traditional Defined Benefit structure of public pensions in all other advanced G-20, all these systems generally use current workers’ contributions to pay for current pensions.

In Italy, however, public pensions play a larger role than in other advanced G-20 countries. The Italian system offers the highest average gross replacement rate (nearly 70 percent of average earnings) and has a relatively high payroll tax rate among the advanced G-20. Even accounting for the already legislated reforms, Italy will still have the highest replacement rate among these countries for many decades—only after 2055 France would have a slightly higher replacement rate.

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Sources: OECD (2009); and IMF staff estimates.

In percent of labor cost.

In percent of average wages.

In the absence of the envisaged adjustments, demographic pressures would increase outlays substantially. In Italy, pension spending would increase from 15¼ percent of GDP in 2010 to 24½ percent in 2050. Other advanced G-20 countries face much less pressing fiscal demands due to demographics, in large part because of their smaller current pension expenditures.

uA02fig07

Public Pension Expenditure, 2010–2050

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Sources: 2009 Ageing Report; and IMF staff estimates.

The Italian pension reform was a crucial response to these enormous demographic challenges. The waves of reforms in 1990s and 2000s included a combination of measures to increase revenues and reduce the generosity of benefits, including via increasing the age prerequisites to access pension (see Box 1). As a result, the authorities’ latest estimates suggest that pension spending would decline from the 2008 level of 14¼ percent of GDP to about 13½ percent of GDP in 2060. Other advanced G-20 countries have also adopted reforms to offset the changes in demographics.

The reform path has not been without setbacks. Over the years, discretionary adjustments to the system have been introduced, some of which delayed or reversed the reform impact. These included a five year delay (from 2005 to 2010) in reviewing the transformation coefficients—an important component of the system that reduces benefits to reflect increases in longevity. Also, increases in the early retirement age were partially delayed (and even slightly lowered for those with 36 years of contributions). As a result of incremental changes, the system continues to be very complex.

Despite these setbacks, the impetus for reform continues. The 2004 reform widened the “exit windows” for claiming early retirement, effectively increasing the early retirement age by up to 9–12 months. The 2007 reform responded to the delay in transformation coefficients by increasing the frequency (from every 10 to every 3 years) of the adjustments and making them administrative (the hearing of parliamentary committees, employers’ federation and trade unions is no longer required). It also set a more rapid increase of the early retirement age to 62 in 2013 instead of 2014, while a 2009 law linked the early retirement age to increases in life expectancy starting in 2015.

Highlights of the Italian Pension Reform

The 1992 reform cut net pension liabilities by about 25 percent. The main changes included: increasing the retirement age from 60 (55) to 65 (60) for men (women); increasing reference earnings from 5 to 10 years (lifetime earnings for younger workers); changing valorization to prices plus 1 percent; increasing contributing years from 15 to 20; and, most importantly, modifying indexation from wages to prices. The 1995 reform adopted a Notional Defined Contribution system in which pension benefits depend on lifetime contributions and GDP growth. The retirement age was set at 57 (with 5 years of contributions), with benefits adjusted depending on the age at which pensions are first claimed. After first receipt, pensions grow with inflation. The 2004 reform raised the minimum retirement age from 57 to 60 in 2008 to 62 in 2014 for those with a minimum of 35 years of contributions, along with widening the “exit windows”. The 2007 reform smoothed the initial increase in the retirement age (from 57 to 58 in 2008) but brought forward the increase to age 62 to 2013 (63 for the self-employed). Additionally, the minimum age requirement was reduced by a year for those with 36 years of contributions. The above age requirements apply uniformly to all three pension regimes (retributive, contributive, and mixed). A 2008 law allowed old age and seniority pensions to be fully cumulated with labor income. In 2009, statutory retirement age of women in the public sector (60 in 2009) was set to increase starting from 2010, to equalize it with age of men (currently 65) by 2018, in response to the European Court of Justice sentence. Furthermore, the 2009 law introduced a five-year indexation mechanism linking the age retirement prerequisites to changes in life expectancy starting in 2015 but implementation mechanisms are yet to be enacted by end-2014.

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Contribution Years Required to Access Pension Regardless of Age

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

uA02fig09

Early Retirement Age for Individuals with at Least 35 Years of Contributions

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Plans to develop private pension schemes, however, have not been very successful. Starting January 1, 2007, severance-pay benefits are to be accumulated in funds outside employers. The Trattamento di fine rapporto (TFR) is a mandatory benefit that employers traditionally financed by book reserves on behalf of workers to be withdrawn as a lump-sum upon retirement or separation. The default destination for future contributions is private pension funds. Workers have the option to opt-out of private funds, in which case the TFR contributions are held by special fund of the INPS (the National Social Security Institute) on behalf of the Treasury. Progress in the development of TFR private funds, however, suffered a setback following the financial crisis—open and closed funds had substantial financial losses in 2008. This fueled an aversion to the risks of private funds. The funds recovered in 2009 but the early enthusiasm seems to have been lost. By December of 2009, about 5 million workers (only about 1/5 of the labor force) had subscribed to these funds. For the remainder, the severance-pay contributions were transferred to the INPS or remained within the firms.

III. Re-assessing Italy’s long-term fiscal sustainability

A. Why Italy looks good and what are the challenges ahead

At first sight, long-term fiscal prospects for Italy do not appear to raise serious concerns. The authorities’ latest projections, based on the envisaged policy scenario (under the excessive deficit procedure requirement of the Stability and Growth Pact) of structural tightening of about 1.8 percentage points of GDP in 2010–12 suggest that public finances are on a long-term sustainable path. Debt would steadily decline to below 40 percent of GDP in 2060, deficit would remain well within the 3 percent of GDP threshold, and age-related spending would stabilize, remaining below the euro area average.

Authorities’ Projections

(Percent of GDP, unless otherwise indicated)

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Source: Stability Programme Update, Jan 2010.

However, this favorable outlook is subject to a number of challenges. First, under these projections, labor productivity and real GDP growth would have to be well above the growth rates evidenced in past decade. Second, near- to medium-term fiscal adjustment, including in non age-related spending and pensions, has to take place as planned, at a minimum, and more so if growth disappoints or there are slippages in medium-term fiscal consolidation. Third, pressures from health and other age-relating spending should be contained.

Assumptions about future growth and its components are key. In the absence of further broad structural reforms, the expected large increase in long-term productivity cannot be readily assumed. Indeed, the authorities’ most recent revisions, which are used in the subsequent analysis, have adjusted the labor productivity growth downwards. However, the assumption that the relatively strong employment dynamics experienced in the past will continue would seem to be at odds with the projected increase in the ratio of inactive elderly to the economically active population.

Macroeconomic Assumpions Used in the Authorities’ Projections

(Average growth rates, percent)

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Sources: For Italy and Germany, projections from Jan 2010 Stability Programme Updates; for Italy*, projections are from Feb 2010 MEF update of long-term social spending analysis (RGS, 2010); for EA and France, projections from 2009 Ageing Report; for Italy, employment growth projections are derived; 1999–2007 from WEO.

Averages over 2020–2035 for EA and France and 2015–2030 for Germany.

Average over 2015–2030 for Germany.

Scenarios discussed below differ from the authorities’ macro-fiscal policy scenario in several aspects. For the medium term, real GDP growth is assumed to be slower and hump-shaped, reaching 1½ percent of GDP in 2012 (in contrast to the authorities’ 2¼ percent) and declining to 1¼ percent by 2015. For the longer term, labor productivity growth and employment growth are both assumed to be weaker than in the authorities’ scenario (itself following the common scenarios adopted in the context of the European Commission and the Economic Policy Committee of age-related expenditure (AWG) work). The authorities’ fiscal plans to scale back one-off crisis-related interventions in 2010 are taken into account, along with most of the consolidation measures under the unchanged legislation scenario. The scenarios without medium-term fiscal adjustment reflect the lack of specific measures to support the authorities’ proposed policy scenario. The starting point (for debt and structural primary balance) in the authorities’ above-mentioned long-term sustainability projections presented in the latest Stability Programme Update is 2012, whereas that in the following exercise is 2015. Lastly, expenditure on pensions, health (‘reference scenario’) and long-term care is calibrated for respective macroeconomic scenarios.7

Lower long-term growth and a lack of medium-term fiscal adjustment would render fiscal situation unsustainable. The debt would reach 400 percent of GDP by 2060 in such illustrative scenario. Assuming the authorities’ optimistic assumptions about long-term growth developments, the debt ratio would reach over 200 percent of GDP (close to the projection in the 2009 Sustainability Report).

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Public Debt -- Without Medium-Term Fiscal Adjustment 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Sources: Ministry of Economy and Finance; and IMF staff estimates.1/ Fiscal projections as in staff baseline for 2010–2015.Assumptions underlying the illustrative scenarios (growth rates are average rates for 2015–2060):A. Lower growth: labor productivity growth 1.00% and employment growth -0.18%.B. Average growth: labor productivity growth 1.20% and employment growth -0.13%.C. Average/high growth: labor productivity growth 1.45% and employment growth -0.16%.D. High growth: labor productivity growth 1.62% and employment growth -0.13% (macroeconomic assumptions used in the Ministry of Economy and Finance projections).

Both strong medium-term fiscal consolidation and increased growth are necessary for fiscal sustainability but may still not be sufficient. The fiscal consolidation (1¾ percentage points of GDP in 2010–2012) envisaged in the Stability Programme Update (SP) combined with the authorities’ optimistic growth assumptions would put the debt on a declining path, and deficit would remain broadly within the 3 percent of GDP threshold. However, even by 2060, the debt-to-GDP ratio would not reach the 60 percent level. Only together with stronger fiscal consolidation—say, ½ percentage points of GDP over the SP effort in 2011–12 is assumed, via non-age related spending cuts, similar to the authorities’ approach in SP—debt will eventually fall under 60 percent threshold (not reported on the chart). Instead, under more realistic—average growth assumptions—even with the stronger fiscal adjustment effort the debt dynamics would reverse, and sustainability concerns may re-emerge. These illustrative findings are summarized in the table with the standard sustainability indicators, pointing also to the importance of addressing age-related spending pressures.

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Sources: Ministry of Economy and Finance; Stability Programme Update, January 2010 (SP); and IMF staff estimates. Assumptions underlying the illustrative scenarios (growth rates are average rates for 2015–2060):A. Adjustment as in SP; high growth: Fiscal adjustment as in Stability Programme Update (1¾ percent of GDP in 2010–2012); labor productivity growth 1.62%; and employment growth -0.13%.B. Adjustment as in SP; low growth: Fiscal adjustment as in Stability ProgrammeUpdate (1¾ percent of GDP in 2010–2012); labor productivity growth 1.00%; and employment growth -0.18%.C. Adjustment as in SP; average growth: Fiscal adjustment as in Stability Programme Update (1¾ percent of GDP in 2010–2012); labor productivity growth 1.20%; and employment growth -0.13%.D. Stronger fiscal adjustment; average growth: Fiscal adjustment of 2¼ percent of GDP in 2010–2012); labor productivity growth 1.20%; and employment growth -0.13%.

Sustainability Indicators: Illustrative Scenarios

(Percent of GDP)

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Sources: Ministry of Economy and Finance; Stability Programme Update, January 2010 (SP); IMF staff estimates.

No fiscal adjustment; low growth (productivity growth 1.00%; employment growth -0.18%).

Fiscal effort as in SP; high growth (productivity growth 1.62%; employment growth -0.13%).

Fiscal effort as in SP; average growth (productivity growth 1.20%; employment growth -0.13%).

Stronger fiscal effort in 2011–12; average growth (productivity growth 1.20%; employment growth -0.13%).

S2=Permanent budgetary adjustment need to fulfil the intertemporal budget constraint.S1=Permanent budgetary adjustment need for debt to reach 60% of GDP in 2060.RPB=Primary balance resulting from budgetary consolidation that ensures sustainability.

Some challenges, however, arise from the assumed evolution of age-related spending, especially pensions. The baseline projections for pension expenditures offer a healthy outlook for the sustainability of the pension system. However, two main challenges lay ahead: first, uncertainty exists due to implementation risks and the sensitivity of some of the assumptions; and second, issues of intergenerational equity remain due to the back-loading of the remaining reform.

Although the authorities have responded to reversal attempts, implementation risks remain. Recent attempts for reversal of the reforms—such as the delay in the update of the transformation coefficient or the more gradual increase in the early retirement age—suggest that the risks of implementation are important. The effects of these delays are not negligible: initial pension benefits were reduced by between 6 and 8 percent for new beneficiaries depending on age after the new coefficients were introduced in 2010. There is a risk that the expected cuts in replacement rates could precipitate further attempts to delay the reform, which could be perceived as the weak link of the reform efforts.

The projected decline in replacement rates points to a larger role for voluntary pensions. The Italian pension system currently includes some sharp cuts in replacement rates, especially for the very young. To ensure individuals have adequate resources in old age and to reduce the risk of reversal, the projected decline in public pensions should be at least partially offset with accumulations in voluntary pensions. Relative to other advanced countries, however, Italy currently has rather small accumulations in private pension funds. Encouragingly, despite the crisis, the number of subscribers to private pension funds increased in 2009 (by about five percent); however the persistently small share of young-age contributors is worrisome.

uA02fig12

Public Pension Expenditure and Private Pension Fund Assets

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Sources: IMF (2010); and OECD (2010).

Other key assumptions might not materialize. A key assumption is that the number of contributors to the system will increase faster than the growth of the working age population (15–64), reflecting the rising labor force participation of women and the increase in effective retirement age. The prospect of lower replacement rates, especially for very young cohorts, however, might increase the incentive to stay in the informal sector. This would reduce the future number of contributors and threaten the financing of the system. Additionally, the extended use of temporary labor arrangements could also reduce contributions over time.

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Excess Growth of Contributors to Working Age Population, 2010-2050

(Percent)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Sources: 2009 Ageing Report; and IMF staff calculations.

While pension reforms have improved the balance across generations, an important burden still remains on future generations. Mainly by introducing price indexation of benefits, the 1992 reform greatly reduced the burden on future generations of workers—net pension liabilities were reduced by about 25 percent. However, intergenerational inequities remain due to the slow transition implied by the reforms which grandfathered individuals with at least 15 years of contributions in 1992 (18 years in 1995)—cohorts covered by the old, more generous system are projected to get benefits until at least 2040. For instance, the net present value of pensions for a current new born are about 75 percent of benefits of a 40-year old and 50 percent of benefits of a 60-year old.8 The current divide in the labor market between different types of labor arrangements could also exacerbate the intragenerational inequities. Simple simulations show that the pension of a worker with a temporary contract in the initial working years would be, other things equal, 30 percent lower than that of a worker with an open-ended contract.9

Future adjustments in pensions are back-loaded. In particular, future adjustments to pensions will kick in more gradually in Italy than in other advanced G-20 countries. Over the next 40 years, the overall changes in pension outlays due to reform are larger in Italy (a decline of 36.4 percent) than in other G-20 countries (a decline of 28.2 percent). However, the remaining effects of the reform are heavily back loaded—about 2/3 of the adjustments are expected to happen after 2020 compared to only about 1/2 of the adjustment after 2020 for the advanced G-20 countries.

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Timing and Size of Implied Replacement Rate Cuts

(Percent)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Source: 2009 Ageing Report.

Despite the reforms, replacement rates will continue to be among the highest in the region for the next couple of decades. These sustained levels of replacement rates—combined with the lack of incentives to delay retirement—will further defer the desired macroeconomic effects of the pension reform and will also limit the role of the private sector for retirement savings.

Although the reforms improved the long-term outlook, significant budgetary demands will arise over the medium term. Official projections show that pension expenditures are set to increase by nearly 1 percent of GDP between 2015 and 2040 (RGS, 2010)—the net present value of this projected increase over 2015–2040 is about 8 percent of 2010 GDP. To offset this projected increase, benefits would have to be cut by about 5 percent between 2015 and 2040 on top of the already legislated benefit adjustments or the retirement age could be increased by one year (accompanied by a shift of the transformation coefficients for those in the new system, to reflect lower benefits at each age of claiming).

The non-contributory component of pension expenditures remains large. Despite the contributory nature of the pension system, a substantial share of expenditure continues to be financed through general taxation (Gestione per gli interventi assistenziali, GIAS). In 2008, these expenditures, which arise from non-contributory welfare pensions, accounted for about 15 percent of the expenditures (2 percent of GDP). More importantly, this level of spending has remained virtually unchanged as a percent of GDP over the last 20 years.

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Pension Expenditures for Noncontributory Pensions, 1989–2008

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A002

Source: Nucleo di Valutazione della Spesa Previdenziale.

Overall, the pension reforms adopted over the years would—if implemented faithfully—significantly reduce the costs associated with aging. The projected size of pensions in relation to GDP has increased in recent years; the system still provides incentive for early retirement and if, anything, the back-loading of the remaining adjustments may strengthen incentives to exit the labor market before these adjustments take place; intergenerational balance is still a key issue; and the strengthening of the second pillar remains sluggish.

Importantly also, there are large uncertainties in the area of health spending. In this area, the projected increase of the costs over time is much higher than for pensions—in the baseline projections of the 2009 Ageing Report, health care spending in Italy is projected to increase by 1.1 percent of GDP between 2007 and 2006 compared to a decline of 0.4 percent for pensions. Furthermore, there is large uncertainty on these projections. Recent staff estimates, using a scenario in which the changes in health spending are more in line with historical trends, point to an increase in health spending of over 2½ percent of GDP between 2007 and 2060. The uncertainty of these projections is also notable in the authorities’ estimates which have been shifting upwards over time.

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Source: Ministry of Economy and Finance.

B. How Italy Can Ensure Long-term Fiscal sustainability

The strategy to ensure long-term fiscal sustainability should be three-pronged: stronger fiscal consolidation in the medium term combined with improved growth prospects should be complemented with adjustments to the pension system and possibly to health expenditure. For illustration, as a central scenario, a somewhat stronger fiscal adjustment (½ percentage points of GDP in 2011–12 on top of the one envisaged by the authorities) and average growth (based on an average long-run labor productivity growth of 1.2 percent) is used. In this scenario, an adjustment in pension expenditure of a minimum 5 percent in nominal terms would be needed to put public debt on a declining path and bring it to just about 60 percent of GDP in the long run. Containing the growth in health spending toward the end of the projection horizon may still be needed to tip the debt ratio down more decisively.

uA02fig17
Sources: Ministry of Economy and Finance; and IMF staff estimates.1/ Fiscal adjustment of 2¼ in 2010–12; average long-run productivity growth of 1.20% and employment growth of -0.13%.

The high sensitivity of public debt to pension expenditures indicates that pension reforms should go ahead as planned. The Italian pension reforms introduced notional contribution accounts, with pension contributions revalued in line with the growth of the economy. The system is also intended to offset changes in life expectancy by periodically adjusting the factor that converts the notional accumulation into the initial benefit. All of these have been steps in the right direction which help isolate pension expenditures from adverse macroeconomic and demographic developments. Nonetheless, the reforms have faced some headwinds from implementation delays. Given the large effects from deviations in the projections of pension expenditures—a 5 percent permanent increase in pension would put public debt on an unsustainable path—it is imperative that the reform continues as planned.

Future pension reforms should focus on automatic adjustments to improve intergenerational equity. One of the peculiar characteristic of the Italian system is that the anchors to macro or demographic variables (such as the valorization of contributions or the periodic revision of the transformation coefficient) affect future generations of retirees while leaving the benefits of current retirees virtually unchanged.10 Future reforms would greatly improve the balance of the burden of the reform by shifting at least part of the adjustment to current pensioners. For example, bringing forward the already planned increase in the early retirement age could yield savings of 0.3–0.7 percent of GDP per year (depending on the assumption about the share of retirees who claim early retirement) in the medium term.11

Adjustment to pension benefits, however, should also ensure compliance with the system. The long-term sustainability of the system depends largely on the need to ensure that future generations of workers comply with the system. The use of notional defined contribution provides incentives to participate in the system by directly linking contributions to pensions. The prospect of lower replacement rates, especially for the very young, however, could deter some workers from participating in the system. Additionally, the use of temporary labor arrangements could also reduce the mass of contributions over time.

Efforts to develop private pension schemes should continue. Private pensions, which are an important element of the retirement income systems of most advanced economies, are notably unimportant in Italy. With the decrease role of public pensions in the future, it is fundamental that private pensions continue to be developed. The expansion of these systems should be supported by a sound regulatory framework and a careful assessment of the capacity of the private sector to efficiently manage these schemes.

IV. Conclusions

There are key challenges to Italy’s long-term fiscal prospects. The authorities’ projections suggest a sustainable fiscal outlook, but they hinge on a number of optimistic assumptions, including: a quick and robust rebound of growth in the medium term; high labor productivity growth in the long run; fiscal consolidation in the tune of 1¾ percent of GDP in 2010–12 with underlying policy measures yet to be identified; and sanguine expectations about the budgetary impact of ageing. The projections also assume the back-loading of the remaining pension reform and face significant uncertainties about other age-related expenditure.

Pension reforms should go as planned, at a minimum, with further adjustments needed to secure fiscal sustainability. It should be a priority to ensure that the reform does not suffer further delays in its implementation—following the scheduled increases in the retirement age, updating the coefficients in a timely and transparent way, and limiting the discretionary adjustments in future revisions of the system. Furthermore, efforts should be made to improve the balance of the adjustment efforts across generations, which is currently tilted against future generations.

The impact of ongoing and future structural fiscal reforms should be assessed in the context of their potential long-run implications for fiscal sustainability. This concerns especially health spending and fiscal federalism reform, in general, as well as budget reforms. While the outcomes of expected budgetary implications of these reforms are not clear yet, the already ambitious fiscal strategy outlined above underscores the need to implement such reforms in a cost-conscious manner.

In sum, to succeed, fiscal sustainability will require bold medium-term fiscal consolidation and strong economic growth in the long run, supported by measures to further ease the budgetary pressures from ageing.

Annex 1: VI. Appendix

Table 1A.

Age-Related Government Expenditure, 2007–2060

(Percentage points of GDP)

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Source: European Commission (2009).
Table 2A.

Parameters of Pension Systems in the Advanced G-20 Countries

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Source: Whitehouse (2008).DB=defined benefit, NDC=notional defined contribution, b=number of best years, L=lifetime earnings, w =w ages, p=prices, NI+sus=nominal income growth and sustainability factor.

Percent of average earnings.

Full career worker.

Percent of individual earnings.

For Italy, the pension access age with 36(35) years of contribution in 2010. The access age is set to increase to 61(62) by 2013. The age requirement is one year higher for the self-employed. A further postponement of about 9–12 months is envisaged through the “exit windows”.

Italy’s Long-Term Fiscal Outlook: Some Highlights in Numbers

  • For every inactive person over 65, there were two employed persons 15–64 age in 2007; in 2060, the relation will be nine-to-ten, the highest in Europe.

  • Public debt reached 115.8 percent of GDP in 2009, the second highest to Japan among advanced G-20 countries.

  • Public pensions consume 1/3 of budgetary resources or over 15 percent of GDP in 2009, the highest among advanced economies.

  • In the absence of the envisaged pension reform, pension expenditure will increase to 24½ percent in 2050, much more than in other advanced G-20 countries.

  • The waves of pension reform have helped improve the balance of fiscal adjustment across generations, but the effects of the remaining reform are heavily back-loaded—about 2/3 of the adjustments are expected to happen after 2020 (about 1/2 for the advanced G-20 countries).

  • The pension reform is not generationally fair—the net present value of pensions for a current new born are about 75 percent of benefits of a 40-year old and 50 percent of benefits of a 60-year old.

  • With no fiscal consolidation in the medium term and lower than envisaged growth in the long run, the public debt will reach over 400 percent of GDP in 2060.

  • A 0.2 percentage point increase/decrease in average long-run labor productivity growth translates, other things equal, into about 60 percentage points of GDP decrease/increase in debt-to-GDP ratio in the no-fiscal adjustment scenario.

  • ½ percentage points of GDP increase in the envisaged fiscal structural consolidation in 2011–2012 will cumulate in the long run to about 35 percentage points of GDP lower debt ratio in 2060.

  • Average long-run growth of about 1.1 percent and fiscal adjustment of 2¼percent of GDP in the medium term would be needed to close the sustainability gap but at the debt level close to that of 2010.

  • Still, at least a 5 percent nominal cut in overall pension costs (or 0.8 percent of GDP) on average will be needed to bring debt close to 60 percent of GDP by 2060.

V. References

  • Balassone, F., Cunha, J., Langenus, G., Manzke, B., Pavot, J., Prammer, D., and P. Tommasino, 2010, “Fiscal Sustainability and Policy Implications: A Post-Crisis Analysis for the Euro Area,” (forthcoming).

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1

Prepared by L. Lusinyan (EUR) and M. Soto (FAD). The authors are grateful to the Ministry of Economy and Finance staff for comments and helpful collaboration. Comments and suggestions received during the 2010 Article IV consultation mission to Italy are also gratefully acknowledged.

2

These estimates use the baseline scenario from EC (2009b); but even in the less optimistic scenario, in which health cost increases are more in line with historical trends, Italy would still have one of the lowest age-related expenditure among the advanced EU countries.

3

For more details, see IMF (2009).

4

Including in-kind social benefits increases non-discretionary spending to 33½ percent of GDP.

5

RGS (2009, 2010) lists several different definitions of pension expenditure depending on the specific social benefit programs included in the calculation. In this annex, the MEF/RGS definition is used, as in the general government fiscal accounts. MEF/RGS definition includes old-age, disability, and survivors (IVS) pensions and old-age means tested transfers (social pensions and social allowances starting from 1995). This definition excludes severance payments (TFR) by private and public employers (estimated at over 1¼ percent of GDP).

6

The financial position of the National Health Service (Servizio Sanitario Nazionale, SSN) has however improved somewhat in recent years, with the deficit of €3.2 billion (0.2 percent of GDP) in 2008 expected to have been covered by the regions.

7

Education spending is based on EC (2009b). The age-related expenditure projections incorporate the impact of immigration, with the net flow of immigrants assumed at about 200,000 annually in the baseline scenario. Increases in immigration would ease pension pressures in the near-term, but would not change the overall picture substantially: according to the authorities, a 40,000 higher net flow of immigration from 2020 would result in a reduction of about ½ percentage points of GDP in age-related spending by 2060, two-thirds of which in pensions achieved mainly after 2040.

10

Once benefits are claimed, they are adjusted proportionally with inflation, with the proportion decreasing with the size of the pension.

11

Other adjustments could include limiting price indexation of pensions to account for increases in life expectancy or the change in the mass of contributors (as in Japan) or to freeze pensions to respond to long-term actuarial imbalances (as in Canada).

Italy: 2010 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; Staff Statement; Statement by the Executive Director for Italy
Author: International Monetary Fund