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Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

Italy -- 2001 Article IV Consultation

Preliminary Conclusions of the IMF Mission

Rome
August 3, 2001

1. The government's medium-term economic program aims to achieve a far-reaching transformation of the economy, through a strategy embracing structural change in product and labor markets and in the public sector-including a durable reduction in taxation. Such reforms unquestionably have the potential to foster more dynamic growth.

2. The mission found a broad consensus, shared by the social partners and financial market participants, that this is a formidable challenge. It requires overcoming a decade of growth that was low relative to Italy's European partners; building on recent progress to achieve much higher and more regionally-balanced employment; and addressing-within the context of the Stability and Growth Pact-fiscal policy demands that stem from a high public debt and an aging population.

3. A prudent strategy must seize the present opportunity-yet guard against undue risks, building on a realistic assessment of the economic and fiscal impact of reforms. Importantly, the government's policy initiatives have a focus that is strongly geared to the medium-term. To leverage these initiatives for a near-term impact-from investment and growth to the emergence of the underground economy-credibility is key. It depends importantly on upfront structural reforms, especially in the area of public expenditure. Much of the mission's discussions focused, therefore, on issues of implementation, including an assessment of risks and trade-offs in the period ahead.

4. The immediate economic setting is one in which a firmly implemented policy strategy could foster a rebound of growth. Currently, the weaker world economy is slowing activity in Italy-although there are also some signs consistent with a pickup of final domestic demand later in the year. Weakness in activity will likely extend through the summer, but GDP growth for this year should reach 2 percent, with perhaps some upside potential in domestic demand. A further acceleration-to more than 2½ percent-is achievable in 2002, though this will depend both on policy execution and a rebound in external demand. And for now, at least, a depreciated euro is amplifying the impact of moderate labor cost increases in ensuring strong competitiveness. Meanwhile, following a temporary acceleration, inflation has begun to decline: the annual rate should drop below 2 percent early next year. This owes much to the approach of labor unions in the private sector, which avoided a spillover of temporary oil and food price rises into longer-term inflation. The payoff of this strategy-and some increase in labor market flexibility-is visible, too, in the strong employment growth of all major regions.

5. In this setting, the government's approach to tax and expenditure reform can play a particularly important role. On taxes, the need, first and foremost, is to establish credibility that they will be reduced-and durably so. In this regard, we strongly welcome the government's intention to proceed with tax reductions only as and when the required expenditure cuts, which must also assure further fiscal consolidation, are firmly in place. Together with a cautious ex-ante costing of tax relief, this should ensure that tax cuts are viewed as sustainable.

6. The impact of cuts in taxes and social security contributions depends also on their specific design and incentive effects. Tax reductions will be particularly effective if they address severe distortions in the economy-including through reforms to lower the tax wedge on labor income and thus facilitate job market entry into the formal economy. We were encouraged by the reflections of the Ministry of Labor and Social Welfare, among others, in this regard. Implemented in this spirit, a simplification and reduction of the income tax and social contributions would be valuable. And looking beyond the lapsing of the Tremonti bis, corporate taxation should provide firms with a predictable framework for longer-term decision-making, and one that treats equitably different sources of finance.

7. Significant tax cuts, coupled with fiscal consolidation, will require sizable cuts in expenditure, relative to GDP. It would be helpful if future updates of the Documento di Programmazione Economico-Finanziaria (DPEF) include details and costing of the measures-a task that will be easier after the government's coming discussions with other parties involved, both regional and social. Moreover, the strategic implementation of the program-and thus its credibility and early impact-would be enhanced if it included agreement in the cabinet of ministers on explicit medium-term expenditure ceilings covering 2001-06, with a commitment also to individual ministerial ceilings.

8. The government's program requires major adjustments in spending, including:

· Public sector and public employment reform. Notwithstanding considerable progress in recent years, there is clearly major scope to enhance efficiency. A streamlining of procedures; the planned effective use of new technologies, including to interface with firms; and a withdrawal of the state from commercial activities, including at the local level, could rapidly improve efficiency and save resources. A sizable annual turnover rate of staff-and mobility within the sector to areas of greatest need-can help markedly improve efficiency.

· Social spending overall is not high by EU standards, but three considerations warrant a review. Most immediate is the plan to reduce taxes over the medium term. This will benefit much of the population-including pensioners, as income taxes are lowered-but will probably not be feasible without reducing (relative to GDP) the largest expenditure item, social transfers. A second issue is the opportunity to rebalance social spending, including toward well-targeted labor market initiatives, since Italy presently allocates an unusually large share of spending to old-age and other pension commitments. Third, looking ahead, healthcare and pension spending is set to rise as the population ages: this must be contained if future tax increases are to be avoided.

· Healthcare and pensions. Containing expenditure and improving efficiency in healthcare requires measures on both the demand and supply side, including pharmaceuticals. In the spirit of devolution, each region should be made accountable-with its own resources-for spending above realistically set transfers. And this accountability needs to be real, not hypothetical. We welcome the government's early move to discuss these issues with the regions: clear signals are needed on restraint-beginning now, not in 2002. Such understandings on healthcare, and other areas devolved, should be reflected in a strengthened Internal Stability Pact that would encompass all activities of the lower levels of government. In this and some other areas, decentralization must be complemented by clear understandings on the role of nationally set standards-and some localities may need help in enhancing their ability to achieve these. On pensions, discussions on the verifica provide a welcome forum to review spending trends and broader issues. Consideration should be given, inter alia, to a more flexible retirement age, and reduced disincentives to work-with a view to raising the effective retirement age. Allowing pensioners to work without penalty is one important measure. A sizable second pillar is needed, with privately-funded pensions.

· Subsidies and tax expenditures should be curtailed. This includes those for the railways and the postal sectors where, notwithstanding considerable improvements, efficiency and tariffs remain low by international standards and cost recovery could be increased. There is room to retrench some ill-targeted active labor market policies, which de facto most benefit regions with low-unemployment; and the oil-price subsidy should not be further extended. Savings are feasible on intermediate public consumption, for example through outsourcing government activities, and through more cost-effective procurement, aided by the initiative to enhance the existing electronic system.

· At the same time, the commitment to raise Official Development Assistance is laudable.

9. A credible expenditure path should lay the foundation for successful medium-term consolidation, and we welcome the renewed commitment to balance the budget by 2003. This is a crucial step in ensuring public debt sustainability-one all the more important in light of recent swings in the public sector borrowing requirement. Decisive early actions are needed to anchor the goal of budget balance by 2003-which appears clearly within reach. In this regard, budget execution in 2001 as well as the 2002 Budget will play a crucial role.

10. Assuming very decisive expenditure control in the remainder of the year-by the state and also by lower levels of government-but otherwise no new adjustments, the 2001 fiscal deficit would reach a level on the order of 1½ percent of GDP, roughly double the target of 0.8 percent in Italy's Stability Program. There would be no improvement vis-à-vis the deficit recorded in 2000. Without firm management, a significantly higher deficit than 1½ percent of GDP would certainly result. Even a deficit of 1½ percent of GDP would fall well short of what is needed to buttress the credibility of future plans, or reflect European commitments-which the government has reiterated. Among other considerations, this year's slippage reflects sizable expenditure overruns, including on healthcare and wages. Only to a modest extent does it reflect cyclical developments; and overall revenues have held up well.

11. The mission advises, in addition to firm expenditure management, not an old-time manovra but that structural expenditure reforms and efficiency improvements start now, rather than on January 1, 2002. This would secure a continuous path of fiscal consolidation, and a smooth transition to expenditure levels (relative to GDP) required by the government's medium-term program. In addition, actions are possible that reduce the deficit but have relatively minor demand effects (bearing in mind current cyclical weaknesses), and are consistent with the government's vision of a reduced role of the public sector-including additional sales of public real estate. Overall, these actions should aim to reduce the 2001 deficit by a further ½ percent of GDP.

12. The 2002 Budget will need to make further progress with structural expenditure reforms. The government's deficit target of 0.5 percent of GDP in 2002 is consistent with moving to budget balance in broadly equal steps during 2002-03. This would imply, on current trends, a need for measures amounting to about 1 percent of GDP in 2002, depending partly on the carryover effects of actions already implemented in the coming weeks. Indeed, expenditure performance in 2002 should benefit from the result of upcoming discussions on expenditure policies with the social partners, and a progressive strengthening of efficiency in healthcare. If a bold structural reform package emerges after these consultations, some tax reduction could yet prove possible in 2002, without endangering the deficit target.

13. The debate over the size of the fiscal deficit and expenditure slippages in 2001 underscores the need for continuing improvements in the quality and timeliness of fiscal data. The statistical issues relate not least to quarterly accruals data for the general government, and timely information on fiscal operations at the regional and local level, an area that has taken on added significance with the increased devolution to subnational levels of government. A joint effort by all concerned parties would be most useful. Moreover, a high public sector borrowing requirement (fabbisogno) is raising interest payments and adding to the debt-the level of which matters critically over the long run for fiscal sustainability. The Bank of Italy has rightly put this measure back on the map-and by doing so has flagged important measurement issues (including that two existing approaches to measuring the borrowing requirement gave significantly different results for 2000). The remaining issues would best be addressed outside the heat of the fiscal consolidation debate, but they are important and relevant. In this context, we welcome the request from the Ministry of Economy and Finance for a Report on the Observance of Fiscal Standards and Codes- which has also been prepared by several other advanced economies.

14. Turning to other structural areas, growth in the formal economy of the South has been more vigorous in recent years, but regional disparities remain immense. Much faster narrowing of these disparities will be essential if Italy's overall growth aspirations are to be met. New measures to encourage enterprise emersione may expand the formal economy: potentially emerging companies must see sufficient benefits-including firm prospects of lower taxes and deregulation, as well as tough enforcement in the future. Planned additional infrastructure as well as a simplification of administrative procedures should help accelerate development of the South, provided they go hand in hand with greater local responsibility and strengthened implementation capacity. The planned expansion of the scope for public- private partnerships deserves support, and it is welcome that those involved are studying carefully the lessons from experience elsewhere.

15. Nevertheless, the hoped-for economic take-off in the South may not be feasible without a more direct attack on one of its key weaknesses: poor labor market performance. And while some progress has been achieved, unemployment rates remain unacceptably high in the South, and more generally are high among women and the young; moreover, labor force participation, nationwide, is currently well below the level envisaged at the Lisbon summit. Some improvements can be expected from the recent liberalization of the job matching system, and of part-time and fixed-term labor contracts. The mission continues to believe that a partnership for skills would be helpful to address some of the key challenges. Targeted at improving employment prospects, particularly for the young, it would seek agreement among the social partners on three mutually reinforcing elements: a commitment to improve job matching and training-where the labor unions rightly seek major progress; a reduction of social security contributions and labor taxes-where the government's medium-term plan could prove effective; and increased wage differentiation in line with productivity, especially for job market entrants. Some regional wage differentiation has been achieved, but too little. Actions along these lines would promote entry into the formal economy by those currently working in the informal sector, where social protection is absent. Finally, on dismissals, substituting lengthy and cumbersome judicial proceedings with flexible arbitration mechanisms could lift employment prospects for some disadvantaged labor market segments-facilitating on-the-job experience and long-term employability.

16. In the financial sector, bank profitability has recorded a welcome improvement. But the Banca d'Italia has rightly flagged a need to raise capital ratios, and this should also encourage banks to redouble their efforts to strengthen cost containment. Banks and borrowers alike would benefit from a broad improvement in the efficiency of the judicial process. Such action would improve the value of collateral and other legal contracts-while further reducing nonperforming loans. There is also a need for a new bankruptcy law for nonfinancial corporations that would facilitate a more efficient management of the affairs of distressed enterprises. With intensifying links between banks and insurance companies, the strengthening of contacts between the Banca d'Italia and the insurance supervisory authority (ISVAP) is welcome.

17. Last but not least, there has been broad progress on liberalizing product markets and promoting competition. Nevertheless, Italy continues to rank poorly in some areas vis-à-vis other industrial countries, indicating considerable scope for promoting competition and efficiency gains. Following through on the government's commitment for additional large-scale privatization should be helpful in this regard. In the electricity sector, the benefits from partial liberalization (including lower prices) could be enhanced by a faster and more extensive divestiture by the dominant company; a full ownership split between electricity production and transmission would help to foster new investment and enhanced interconnectivity, as foreshadowed in the DPEF. In many other areas, economic gains could be reaped from streamlining, and in some cases eliminating, economic regulations, or from forceful implementation of past deregulation, including at the local level. Examples include the relative scarcity of larger retail outlets, and entry restraints affecting some of the liberal professions.

18. The mission would like to thank the authorities for their exceptional cooperation.