Based on the economic literature, various policy measures and institutions in the product and labor markets that increase growth and employment are studied. From a cross-country approach, this study finds a significant relationship between Vertical Fiscal Imbalances (VFIs) and fiscal performance in OECD countries. Different measures of vertical imbalance are used. To assess the impact of a vertical gap, a panel equation is estimated that is related to general government primary balance to vertical balance, spending decentralization, covariates, and interaction terms.

Abstract

Based on the economic literature, various policy measures and institutions in the product and labor markets that increase growth and employment are studied. From a cross-country approach, this study finds a significant relationship between Vertical Fiscal Imbalances (VFIs) and fiscal performance in OECD countries. Different measures of vertical imbalance are used. To assess the impact of a vertical gap, a panel equation is estimated that is related to general government primary balance to vertical balance, spending decentralization, covariates, and interaction terms.

I. Structural Reforms And Growth: What Works?1

Based on the economic literature and international experience, this annex identifies the policy measures and institutions in product and labor markets that boost growth and employment. Evidence points to substantial long-term growth gains for structural reforms in Italy. Advancing structural reforms in key bottleneck areas can lift productivity, and substantially enhance growth potential. Measures could focus on pursuing further product market liberalization, reducing the labor tax burden- matched by expenditure cuts, promoting decentralized wage bargaining, and addressing labor market dualism. Labor and product market reforms are complementary.

A. Diagnosis

1. In the last decade, Italy has suffered from low economic growth, weak productivity, and declining competitiveness. Total factor productivity (TFP) has been sharply declining over the last decade, which has resulted in persistently rising unit labor costs, stagnating incomes, a widening competitiveness gap, and anemic growth. The weak productivity growth has been attributed to a number of structural factors, including: (i) policy and regulatory rigidities limiting competition and hindering the business environment; (ii) low efficiency, linked to the preponderance of small and medium-sized enterprises that are unable to exploit fully economies of scale; (iii) limited process and product innovation, hindered by labor market rigidities; (iv) the comparatively low level of education; (v) pervasive inefficiency in public expenditure; and (vi) the low-skill specialization pattern, given a production structure (especially in manufacturing) based on traditional products. This annex focuses on the role of product and labor market reforms in fostering TFP, growth, and employment.

A01ufig01

Contribution to GDP Growth

(Percent change)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A001

Sources: EU Commission; and IMF staff calculations.

Why is Italy lagging behind?

The weak growth performance can be attributed to a number of structural factors, including:

• Low educational attainment and inadequacies in tertiary education. The level of educational attainment in Italy is among the lowest in the OECD area. Only slightly more than 10 percent of the working age population has a tertiary degree compared with the OECD average of 26 percent. Despite high education expenditure per student, the average educational outcomes of a typical 15-year old Italian student are among the poorest according to the OECD PISA study.

A01ufig02

Education attainment indicators point to Italy’s lagging performance.

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A001

Sources: Eurostat; WEO; and IMF staff calculations.1/ Data for Italy, Greece, EA, and EU 27 as of 2008.2/ Comparing countries’ and economies’ performance on the math scale.

• Excessive regulation. In many areas, Italy’s regulatory policy and practice lags far behind best practice in Europe and the OECD. Parts of the service sector remain highly protected from competition or encumbered with excessive regulation, sometimes varying across regions. Inefficiencies in public administration also add to the obstacles faced by the private sector.

• A predominance of small and medium-sized enterprises, which are unable to exploit economies of scale. Owing to regulatory, corporate governance, financial, and cultural reasons, SMEs are predominant in Italy. Growing beyond a certain point, where family and close personal connections can no longer serve to enforce contracts requires a considerable increase in risk and costs of control. The traditional importance of personal or family control has also limited the use of non-bank SME financing. The equity markets remain underutilized as a source of SME financing and venture capital has also been slow to develop. Holding structures tend to obscure beneficial ownership and to give some insiders a degree of control that significantly exceeds their share.

• The tax burden is one of the largest in OECD but public expenditure is very inefficient, especially in the South.

• Weak judicial system. Delays of civil justice are among the longest in all OECD countries. Courts are very slow to resolve cases. Incentives faced by lawyers tend to encourage longer trials: lawyers are paid for each judicial act, so they tend to multiply the number of acts they perform.

• Scarce innovation and R&D activity. Expenditure on R&D in Italy is slightly above 11 percent of GDP, compared with the OECD average of 2.3 percent. The small size of Italian makes it difficult to meet up-front cost of R&D. R&D in universities or research institutions is underdeveloped in Italy.

• Regional divide. Italy is characterized by large regional disparities in terms of per capita income as well as labor market performance, in particular between the developed Center-North and the lagging South. Per capita GDP in the South is almost half of that in the North, reflecting lower productivity and, more importantly, substantially lower employment rate disparities. Italy’s coefficient of variation for the regional long-term unemployment rate is the highest among OECD countries, while its coefficients of variation for the regional youth unemployment rate and for the regional labor force participation rate are some of the highest (see Selected Issues II).

A01ufig04
Source: OECD, TL23and TL2 regional breakdowns.

2. The competitiveness gap widened. Economic rigidities, along with Italy’s historic specialization in products with relatively low value added, contributed to a steady erosion of competitiveness. Italy’s market share in world trade has declined significantly (and more than its peers) since the mid 1990s. Earnings growth outpaced the growth in labor productivity over the last decade. As a result, Italy’s unit labor costs grew by nearly 25 percent cumulatively during 1999–2007. The real exchange rate has steadily appreciated on account of moderately higher inflation and unit labor cost increases exceeding those of trading partners. The consumer price index, producer price index, and unit labor cost-based real effective exchange rate measures point to a loss of price competitiveness.

3. Structural impediments hinder product market performance. The high level of product market regulation hampers productivity growth and incentives for innovation. While the OECD’s product market reform (PMR) indicators suggest that there has been considerable progress since the start of the EMU, the reform process has lost momentum since early 2000s. Compared to the other euro area countries (including France, Germany, Netherlands, and Spain), improvements were achieved, but Italy is still more heavily regulated than its peer countries on some accounts. The key remaining weaknesses are the high levels of public ownership, especially at the local level, regulatory barriers to competition, administrative burdens to startups, and constraining regulations for professional services (OECD 2009).

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Source: OECD PMR database.
A01ufig05

Italy: Business Demographics, Average 1998—2007

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A001

Sources: Eurostat; and IMF staff calculations.
Figure 1.
Figure 1.

Structural Indicators for Product Market

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A001

Source: OECD.

4. Despite substantial improvements over the past decade, Italy’s labor market performance still lags behind other European economies. Employment rates continue to be substantially lower than those in most other European countries. Furthermore, employment rates vary strongly across socio-economic groups. While the employment rate of prime-aged males is often at or above 71 percent, the low employment rates of women, older workers, youth considerably reduce overall employment rates. Labor utilization varies considerably across regions. In addition, the tax wedge, especially for low-skilled workers, remains high (Figure 2) and depresses labor utilization.

Figure 2.
Figure 2.

Italy and EU15: Tax Wedge 1/

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A001

Sources: OECD; and IMF staff calculations.1/ For a one-earner married coupleat 100% of average earnings, with 2 children.2/ SS stands for Social Security contributions and PIT for Personal Income Tax.
A01ufig06

Italy: Selected Labor Market Indicators

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A001

Sources: OECD; World Economic Forum, The Global Competitiveness Report 2010-2011;and IMF staff calculations.1/ GDP-weighted average of Sweden, Denmark and U.K.2/ Higher index denotes weaker performance.

5. Asymmetric polices have also exacerbated disparities in the labor market. Italy’s social safety net is generous for some workers, but virtually nonexistent for (most) others; the extent of the employment protection varies substantially across workers; and the aggregate wage distribution is too compressed. As a consequence, a rising share of workers faces high employment risk but little income insurance. The existing wage bargaining system also exacerbates these disparities: nationally bargained wages are less binding in the North, but too high for South, preventing sufficient spatial mobility to more quickly reduce regional disparities. There is also no general unemployment insurance.

B. Some Evidence from the Literature

Product Market Reforms

6. The product market regulation affects resource allocation and productivity. Such regulation encompasses the barriers to entrepreneurship, the constraints to business operations as well as red tape and administrative burdens. Removing entry barriers lowers the cost of doing business and enhances firms’ productivity. Higher degree of market competition reduces the incumbent firms’ market power and price mark-ups, and induces the exit of less productive firms. Therefore, a more competitive market can enhance the allocation of resources across sectors and firms within the same sector, productivity of existing firms, and incentives for innovation2.

Figure 3.
Figure 3.

Structural Indicators for Labor Market

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A001

Souroe: OECD

7. Cross-country evidence supports a positive long-run impact of competition-enhancing reforms on growth and productivity. A number of studies establish a strong positive relationship between the effectiveness of competition policy and long-run growth (Dutz and Hayri, 1999; Nicoletti and Scarpetta, 2003). Salgado (2002), using a panel of 20 OECD countries for the period 1985–1995, shows that the impact of structural reforms on productivity may be weak or negative in the short run, possibly due to adjustment and learning costs. In contrast, he estimates the impact of product market reforms on total factor productivity growth to be between 0.2 and 0.3 percentage points a year in the long run. Bayoumi et al (2004) calculate that pro-competition product market reforms, which lower price mark-ups in the euro area to the US level, would increase output by some 8.6 percent (relative to its baseline level) in the long run.

8. A more competition-friendly environment could also boost employment. Nicoletti et al. (2001) provide empirical evidence in favor of a significant negative effect of anticompetitive product market regulation on employment in a panel of OECD countries, controlling for labor market policy and institutional factors. The results suggest that in some countries the product market regulatory environment may account for up to 3 percentage points of deviation of the employment rate from the OECD average. Bassanini and Duval (2006) highlight that product market reforms could boost female employment through three channels. First, excessive regulation restricts the supply and drive up the prices of services such as childcare and household services. Second, restricted opening hours of shops make it difficult for women to reconcile work and family life. Third, product market reforms could foster the expansion of service sector where female employment is concentrated.

9. In particular, enhancing competition through facilitating entry or the threat of entry stimulates productivity growth. This generally occurs through two main channels, namely external and internal restructurings. In the external restructuring, eliminating barriers to entrepreneurship reallocates resources among firms. Low productivity firms exit the market and are replaced by new entrants, with the more efficient firms surviving. Consequently, a change in market shares among incumbents will increase sectoral productivity growth. At a firm level, free entry and exit can spur internal firm restructuring, known as “within effect,” through organizational change, adoption of new technologies, R&D activities, and more efficient allocation of factors of production. Nicoletti and Scarpetta (2003) demonstrate that entry liberalization lead to productivity gains over a ten years time horizon in all of the OECD countries considered regardless their position in terms of technology adoption. In addition, they estimate that entry liberalization in service industries boosts annual aggregate TFP growth by about 0.1–0.2 percentage points in countries like Portugal, Greece, and Italy.

10. Firm level evidence confirms substantial productivity gains of reforms aimed at facilitating entry and exit of firms. Disney et al. (2003) find that entry, exit, and the reallocation of market shares (external restructuring) account for 50 percent of labor productivity growth and 90 percent of TFP growth for the UK manufacturing sector during 1980–1992. Similarly, Bartelsman et al. (2003) establish that entry and exit contribute 20 to 40 percent of aggregate productivity growth. And excessive administrative regulations of entrepreneurial activity have a strong negative impact on firm entry and this effect is even larger for small and medium sized firms. Cincera and Galgau (2005) estimate that a 1 percent increase in the entry rate leads to a contemporary increase in output, employment and labor productivity growth rate of 2.2 percent, 2.7 percent, and 0.6 percent respectively and that a 1 percent increase in exit rate reduces output growth rate by 0.8 percent (one year lag), while increases labor productivity growth by 0.7 percent (2-year lag).

11. Simulation-based quantifications suggest that reducing administrative costs translate into higher productivity. Tang and Verweij (2004), employing a general-equilibrium model, estimate that reducing the administrative burden by 25 percent leads to a 1.7 percent increase in EU real GDP in the long run, reflecting higher capital accumulation and R&D spillovers. Likewise, the European Commission (2006) indicates that a 25 percent reduction in the red tape in the EU pays off in a 1.4 percent increase in real GDP in the long run.

12. Reducing government ownership can also have positive effect on growth. The state-owned firms are usually less efficient due to misaligned incentives and soft budget constraints. Nicoletti and Scarpetta (2003) estimate that a gradual reduction of the share of state-owned firms to the OECD-wide average increases annual MFP productivity growth by about 0.7 percentage points in the European countries that have a large stake of government-controlled business activities, such as Finland, Greece, Austria, France, and Italy. Alesina et al (2005) show that deregulation and privatization have similar positive effects on firm investment.

13. Evidence shows a non-linear impact of the product market reforms on innovation. Aghion et al. (2002) find that productivity growth of incumbent firms reacts more positively to entry in industries close to or above the world technological frontier and establish an inverted U relationship between competition and innovation. Griffith et al (2006) confirm that competition increase innovative activity by incumbents, but it decrease incentives for new firms to enter into the innovation process. However, within an industry, the effect of increasing competition on innovation is larger in countries that are closer to the global technological frontier.

Summary of Empirical Studies on Effects of Product Market Reforms

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Labor Market Reforms

14. Labor market policies and institutions influence employment and growth. This section focuses on evidence for labor market features that are most relevant to Italy. These encompass the design of the tax system, employment protection legislation, and wage bargaining system. Taxes that raise the total labor cost reduce labor demand and employment. Also, high tax wedge can create disincentives to work in some segments of the labor market (low-skilled persons and second earner in a couple), reducing the potential labor supply. Stringent labor market regulation can decrease the speed of adjustment in response to demand or technology shocks, reduce the incentive for firms to innovate, and slow down the labor allocation process to its most efficient use. For instance, employment protection legislation strengthens the bargaining power of insiders compared to outsiders, implying that the responsiveness of wages to economic conditions might be lowered. Wage bargaining system could undermine employment performance if they result in an average wage level that is too high relative to productivity; or in a compressed wage structure which does not adequately reflect differences in productivity between workers and regions.

15. Cross-country analysis confirms that a lower labor tax wedge reduces unemployment and yields long-run growth gains. Labor tax burden comes out significant in most studies that analyze the impact of labor market institutions on macroeconomic performance. Bassanini and Duval (2006) find that higher labor taxes raise unemployment, with a 10 percentage point reduction of the tax wedge lowering the equilibrium unemployment by 2.8 percentage points and increasing the employment rate by 3.7 percentage points. They also report a rise of 1 percentage point in tax wedge leading to a decline of 0.05 to 0.2 percentage points in female full-time employment rate and of 0.14 to 0.42 percentage points in the female part-time employment rate. In terms of the effect of labor tax changes on potential output, Barnes et al. (2011) find that reducing the average tax wedge by 10 percent raises long-term growth by 2.1 percent in an average OECD country. The European Commission (2010) estimates that a one percent tax shift from labor to VAT would eventually raise potential output by 0.3 percent.

16. Evidence highlights the adverse effects of a high level of employment protection legislation (EPL) on the employment of disadvantaged groups. EPL could reduce job creation and destruction as a result of higher labor adjustment costs for employers. Empirically, the impact of EPL on the aggregate unemployment rate is ambiguous. Elmeskov et al. (1998) and Boeri et al. (2000) find a positive effect in some of their estimated equations, while Nickell (1997) and Nickell et al. (2005) find no significant effect. In general, the negative impact of EPL on the aggregate employment is not robust (Mourre, 2006). In contrast, the results are more robust when it comes to the employment of workers from groups at the margins of the labor markets. Bassanini and Duval (2006) report that one point rise in EPL leads to a decrease of 1.5 in full-time female employment rate, and to a decline of 2.35 in youth employment (5.4 when controlling for minimum wages). In Barnes et al. (2011), a 10 percent reduction in EPL leads to a long-run increase of 0.6 percent in GDP per capita in an average OECD country.

17. The relaxation of restrictions on temporary employment alone accentuates labor market dualism. Easing EPL only for fixed-term contracts strengthens the power of permanent workers in wage bargaining, which could potentially raise wage mark-up. “Insiders” on permanent contracts can raise their wage claims as they may feel more sheltered from job losses. The resulting negative effects on employment will be borne mainly by the “outsiders” who work on temporary contracts, raising inequalities and possibly reducing the responsiveness of wages to shocks. Blanchard and Landier (2002); and Cahuc and Postel-Vinay (2002) argue that such asymmetric reforms increase unemployment and decrease welfare. Additionally, deregulated temporary contracts can have an adverse impact on human capital formation as the increase the turnover of the workforce reduces the incentive of employers to supply adequate level of training to staff in temporary contracts.

18. More decentralized wage bargaining boosts the employment for the groups “at the margin” of the labor market. Coordinated bargaining entails greater wage compression, with negative effects on relative employment, especially at the bottom of the wage distribution (Blau and Kahn, 1996). Centralized wage bargaining institutions tend to raise the relative wages of the young and less-educated and to lower employment for these groups (Kahn 2000). Wage compression also modifies the industry distribution of employment, shifting employment away from industries with low wages (Davis and Henrekson, 2000), and can exacerbate regional employment disparities. Bertola et al. (2002) highlight that centralized wage-bargaining together with a high degree of unionization lowers the female employment rate, while preserving a high employment rate for prime-age men, as the unions tend to negotiate large wage premiums for those with high opportunity cost of employment. The European Commission (2010) estimates that wage mark-up reductions would have significant positive impact on long-run growth. Eichengreen and Iversen (1999) contend that as growth becomes increasing reliant on rapidly changing, science-based, skilled-labor-intensive technologies, and countries with centralized wage bargaining will have to move further in the direction of decentralization.

Summary of Empirical Studies on Effects of Labor Market Reforms

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Complementarity between Product and Labor Market Reforms

19. Product liberalization spurs more difficult labor market reforms. When product market reforms erode rents and profit margins, incentives for workers to demand a share in those rents is weakened, lowering resistance to wage moderation and other labor reforms. Blanchard and Giavazzi (2003) argue that as product market deregulation decreases total rent, it can induce a decrease in the incentive of workers to appropriate the smaller rents, thus facilitate labor market deregulation. In their model, product market reforms take the form of an increased substitutability between goods. In the short run, such reforms lead to lower mark-ups, reduced unemployment and higher real wages. In the long term, however, this result is conditional on a reduction in barriers to entrepreneurship.

20. Empirical evidence supports the reinforcing feedback between labor and product markets. Nicoletti and Scarpetta (2005), and Bassanini and Duval (2006), among many studies in this area, point to strategic complementarities between labor and product market reforms. Estevao (2005) concludes that excessive regulation suppresses the beneficial effects of labor market reform on employment and output, by inhibiting competition or discouraging entry into the market. Berger and Danninger (2005) find sizable employment gains when labor market liberalization is accompanied with more competitive product market. A country moving from median levels of regulation to the lowest decile stands to gain 1 percentage point in annual employment growth, owing to spillovers from joint deregulation.

C. Lessons from International Experience

21. Poor macroeconomic performance can generate structural reform momentum. Output contractions and prolonged periods of slow growth spurred labor and product market reforms in several countries, including Ireland, the Netherlands, Canada, New Zealand, and the UK. For instance, New Zealand launched a sequence of structural economic reforms, triggered by a foreign exchange crisis in 1984. The crisis created a widespread recognition of the need for change; in addition the governing party parliamentary majority helped the government push the structural reform agenda with few constitutional impediments. Empirical evidence in Drazen and Grilli (1993), IMF (2004), and OECD (2006) suggest that the most promising time to reform is immediately after a crisis.

22. Coordination among social partners facilitates reforms. Unilateral reforms are more likely to be reversed than those negotiated with social partners. The active cooperation among key stakeholders achieves effective implementation. For example, reforms in Ireland and the Netherlands were based on consensus between social partners, trading wage moderation for labor tax cuts. Both countries set the stage for a long-run decline in the size of government and reduced tax wedges on labor income. The resulting employment gains came unambiguously from the private sector (Annett 2008).

23. An effective communication strategy is key to ensure public support for reforms. Tompson and Dang (2010) highlighted that government good communication was crucial to implement reforms (Italy: Dini reform; Germany and Spain: labor market; Netherlands: disability insurance). Consistent and coordinated communication efforts create public support for the reform and allow feedback from key stakeholders to further refine reform design. Clarity in communicating the reform goals and objectives can reduce the likelihood of reform reversals (Swedish: sickness insurance reform reversal in the 1990s). Moreover, communicating the costs of status quo (non-reform) would raise public awareness of the need for reforms.

24. Government cohesion and “ownership” of reforms are key success factors. The unity of the government behind reform is of crucial importance. According to Tompson and Dang (2010), in most cases where there was public conflict within the government or the governing party over a reform, the reform was eventually hindered. Many successful episodes are also characterized by clear “ownership” of reform initiatives. In a number of cases, reforms were clearly associated with identifiable individuals or institutions that assumed ownership and an interest in their success (France, Italy: pensions; Italy, Germany: labor market; Netherlands: disability insurance).

25. Establishing an independent review and advisory body could foster reforms. By providing independent and transparent policy analysis, such institutions can strengthen the quality of policymaking and help focus on priority areas. They can also neutralise vested interests, and build community-wide support by creating awareness of the costs of existing policies and the benefits from reform (Banks, 2010). Examples of these institutions include Australia’s Productivity Commission or the Netherlands Bureau for Economic Policy Analysis.

26. Co-operation of different levels of government matters for the success of structural reforms.3 Inter-governmental cooperation in policy-making is a key framework condition for reforms. Strengthening cooperation may have to be a part of the reform agenda, as it was in Australia in the early 1990s. Sub-national governments may serve as an impetus or an impediment to reforms. In three cases (Germany: retail; United States: welfare reform; Australia: electricity), sub-national governments played an important role in both advancing and designing the reforms eventually adopted. In contrast, the federal dimension sometimes complicated reform implementation (Germany: labor market), while in others resistance from sub-national governments impeded reforms (Spain: retail; Australia: water). Thus, involving sub-national governments in national-level reform debates and building wide-based consensus across different level of governments are crucial for ensuring successful reforms.

27. There is no free lunch, reforms take time and can be painful. Successful reforms generally took over two years to prepare and adopt, involving a considerable amount of careful study and consultation (Italy: labor market; United States: welfare reform; Australia: electricity), whereas many of the least successful reform attempts were undertaken in haste, often in response to immediate pressures (Tompson and Dang, 2010). In addition, structural reforms can be costly in the short-run and benefits take time to materialize. Country experiences, such as New Zealand and the UK, illustrate that reforms can take years and sometimes decades before translating into better economic outcomes. New Zealand experienced sluggish economic growth performance during the reform period. In the UK, reforms took some time to bear fruit as the unemployment rate remained elevated for almost a decade. Empirical cross-country evidence in IMF (2004) corroborates this conclusion.

28. Comprehensive reform packages yield better economic outcomes than a “piece-meal” approach. Utilizing the complementarities between fiscal consolidation and structural reforms enhances labor supply and improves macroeconomic performance. Annett (2008) highlight how the mix of fiscal, labor, and product market reforms complemented and reinforced each other in the case of Denmark, Ireland, the Netherlands, and the UK. These countries implemented labor and product market reforms simultaneously, while engaging in substantial fiscal consolidation. This finding is also consistent with evidence in Hobza and Mourre (2010), where reform gains were found to be considerably higher in the case of comprehensive reform packages than in the case of a “piece-meal” approach.

D. Required Actions: What Needs To Be Done?

29. Structural reforms need to be prioritized on key bottlenecks. On the product market side, remaining weaknesses in the business environment and competition policy framework hamper business activity and entrepreneurship. The regulatory framework still entails lengthy and costly procedures for enforcing contracts, dealing with licenses and starting a business; the overall administrative burden on firms is high and the degree of competition in services remains relatively low. On the labor market side, employment and participation rates of women, youth and older workers remain significantly lower than the euro area average, with large regional disparities. The tax wedge remains relatively high and depresses labor utilization. The existing wage bargaining system does not sufficiently reflect differences in productivity and cost of living, and thus exacerbates regional disparities. The asymmetric deregulation has tilted incentives for job creation toward temporary contracts, resulting in higher employment risk for an increasing fraction of the labor force and contributing to worsening productivity trends. According to Codogno and Felici (2008), despite Italy’s progress in a number of these weakness areas, identified by the EU and the OECD, it was insufficient to close the gaps with the EU 15 average (Table 1).

Table 1.

An overview of performance in each policy area at aggregate level - 2009

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Source: Codogno L., and Felici, 2008Note: For each policy area the overall quality of coverage by narrow list indicators is signalled: *** stands for broad coverage, **mediumcoverage and * narrow coverage. This table presents the aggregate continuous score for each policy area, which is a weighted average of the values of the indicators in the narrow list. The scores for individual indicators are computed as follows: score = 10 * (indicator- EU15average)/standard deviation EU15. The results indicate the levels for the latest available year and progress made (change). Consequently, a score of 10 means that the value of the indicators is 1 standard deviation above EU-15 average. The policy area is considered as underperforming if the aggregate score is below –4. The table also shows the number of underperforming indicators (their scores are less than –4) in the narrow list (both in terms of level and growth) as well the total number of indicators in the narrow list.

30. Studies have identified some key growth enhancing reform measures. IMF (2010), the European Commission (2010), and Barnes et al (2011) pinpoint those product and labor market reforms that are the most effective in boosting growth. On the product market side, the most promising reforms are those leading to the reductions in final goods market mark-ups (e.g.: services), the reductions in administrative burden and the increases in the skills of the workforce. Among labor market reforms, evidence suggest that the most efficient ones would be reducing average and marginal tax wedge, and shifting tax from labor to VAT.

31. Potential productivity and output gains from further product market deregulation are promising. Policies should ensure an efficient regulatory business environment and promote a higher degree of competition through further opening up of services and network industries, reducing public ownership especially at local level, and improving administrative efficiency. Stronger competition would allow new entries in the various sectors, fostering both innovation and efficiency, hence stimulating private investment and employment. IMF (2010) estimates that moving towards “best practices” (defined in terms of OECD PMR indices) raises overall productivity growth in the range of ¼ to over ½ percentage points per year. Similarly, Barnes et al. (2011) present evidence that a 10 percent reduction in overall product market regulations increases long-run growth by 3.8 percent. According to simulations in OECD (2009), aligning Italian regulatory standards to the 75th percentile of all EU countries in 2007 in all non-manufacturing could raise the level of productivity by about 14 percent over the next decade, with the largest gains expected from professional services reforms (7 percent).

32. Lowering Italy’s relatively high average tax wedge can boost employment and growth. Italy has a relatively high tax and social security burden on labor income. Single taxpayers at average earnings end up with less than 55 percent of what they cost to their employer (total labor costs), meanwhile taxpayers at higher earnings get even less than 50 percent. The average tax wedge is about 10 percentage points higher than the OECD average.4 Single-parents earning two thirds of the average wage faces the lowest tax wedge, which remains about 8 percentage points above the OECD average. Simulations by the European Commission (2010) and OECD (2009) find that reducing labor taxation, through shifting taxes away from the labor factor and toward consumption or reducing the average tax wedge, is among the most effective labor market reforms for lifting growth potential. According to Barnes et al. (2011), lowering the Italian average tax wedge to the OECD average would raise GDP per capita by 8.4 percent in the long-run, the highest potential growth gains for structural reforms in Italy based on their simulations. Reducing Italy’s labor tax wedge over 10 years to the average level prevailing in the six OECD countries with the highest employment rate can deliver sizeable long-run employment gains of almost 4 percent (Bouis and Duval, 2011).

33. Promoting decentralization of wage bargaining could enhance the labor utilization and reduce substantially regional disparities. Labor utilization remains low, especially among youth, the elderly, and women, and in the South. Evidence suggests that decentralization can especially benefit those underutilized groups “at the margin” of the labor market. Decentralized bargaining allows higher relative wage flexibility and leaves wider room for bargaining on working conditions more generally. It also makes possible the introduction of performance-related pay schemes where wages are used to motivate and improve workers’ productivity. A decentralized system, which integrates regional differences in productivity and cost of living into wage setting, can reduce regional labor market imbalances. The government should adopt regionally differentiated wages in the public sector in order to reflect differences in cost of living. In light of high employment concentration in the public sector in the South, such reform can increase incentives for internal labor mobility and help reduce regional labor market imbalances.

34. Policies should reduce labor market dualism. Similar to some other European countries, Italy adopted some asymmetric reforms to increase labor market flexibility, by which regulations on temporary contracts were relaxed while maintaining strong employment protection for permanent workers. The time-limited nature of temporary contract reduces incentives for human capital investments and temporary employment creation tends to be in low-skill areas. Also, the still high protection of permanent contracts continues to make it difficult to lay off non-productive workers on permanent contracts. Consequently, the overall result has been a bias towards less-productive employment. Evidence also shows that a pervasive dual system, with a flexible temporary workforce and a highly protected permanent workforce, can actually increase unemployment (Blanchard and Landier; 2002; Jaumotte, 2010; and Dao and Loungani, 2010). Reforms to rebalance employment protection—with a view to support job creation—by relaxing protection on regular workers while enhancing it for temporary workers would be beneficial for reducing unemployment. Such reforms would create a more level playing-field for all workers and enhance social cohesion.

35. The benefits of reform will take time to materialize. Potential growth gains from addressing Italy’s structural bottlenecks are sizable in the long term but uncertain in the short run. A bundle of reforms, if taken in parallel, can raise long-run growth in the range of 4 to 14 percent (Barnes et al, 2011; and OECD, 2009). However, estimated impact of structural reforms on potential output should be interpreted with caution. Simulations do not usually allow for a straightforward comparison across reforms types, complicating comparative assessment of their possible quantified effect on potential output. In addition, estimates do not fully take into account (i) upfront costs of reforms and therefore the short-run impact is uncertain, and (ii) the potential synergies and complementarities of different reform measures. IMF (2004) finds that the cumulative gains from structural reforms in the product and labor market areas are positive but they predominantly materialize in the long run. In the short term, the estimated output responses are small or even negative. The only exception is tax reforms where reform payoffs are substantial even in the short term.

36. The required structural reforms are expected to have a positive long-term effect on public finances. Regulatory reforms have no short-term fiscal costs and potential long-term gains. Competition enhancing polices and deregulation of professional services could raise corporate and labor tax revenues as a result of higher generated activities. On the other hand, the design of labor market reforms matters for their short-term budgetary effect. The reduction of average tax rates, if not matched by expenditure cuts, would reduce revenues in the short run, but will raise tax base in the longer run. A shift from labor to consumption taxation would not adversely affect public finances in the short term, assuming the same level of tax compliance across these two types of taxation. Other measures such as decentralization of wage bargaining, allowing differentiation of wage by regions and productivity, is likely to be budgetary neutral. Addressing labor market dualism by reducing EPL for permanent contracts will also have a neutral fiscal impact.

37. Only a comprehensive reform package can deliver strong growth over the medium term. Complementary labor and service sector reforms are essential to boost job creation, investment, and growth. The extent of the macroeconomic gains will depend on the depth and breadth of undertaken reforms. Measures could focus on pursuing further product market liberalization to promote competition. Reductions in the labor tax burden, matched by expenditure cuts, could be particularly effective as cross-country studies suggest. In this connection, a timely fiscal consolidation would allow a reduction of the tax wedge, which is among the largest in EU. Promoting decentralized wage bargaining would allow wages to be more aligned with productivity, providing firms with better incentives to invest. Reforms to address labor market dualism, through harmonizing labor contracts and employment legislation between permanent and temporary employment, can boost employment and social cohesion.

38. International experience points to some critical success factors in designing structural reforms. The current recovery provides a unique opportunity to embark on growth enhancing structural reforms. Complementary labor and product market reforms along with expenditure-based fiscal consolidation reinforce each other. Comprehensive reform packages yield better macroeconomic gains than “piece-meal” reforms. An effective communication strategy plays a major role in raising public awareness of the need for reforms and the costs of status quo (non-reform), and in seeking buy-in from key stakeholders. Establishing an independent review and advisory body for reforms could foster consensus and focus policies on priority areas, while ensuring the continuity of the reform agenda. The government’s unity behind the reform plans and the ownership of the initiatives are crucial prerequisites. Involving sub-national governments in reform debates and building wide-based consensus across different levels of governments, especially in light of fiscal federalism, will be crucial for ensuring successful reforms in Italy.

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1

Prepared by Hanan Morsy (EUR).

2

See Schiantarelli (2010) for a comprehensive survey of the literature on the impact of product market regulation on macroeconomic performance.

4

Average tax wedge is calculated as the average income taxes plus employee and employer social security contributions minus cash transfers as a percentage of total labor costs.

Italy: Selected Issues
Author: International Monetary Fund