Mission Concluding Statement 

Italy -- 2002 Article IV Consultation, Conclusions of the Mission

June 11, 2002

INTERNATIONAL MONETARY FUND

Italy-2002 Article IV Consultation

The 2002 Article IV mission would like to thank the Italian authorities, the social partners, and others we met for their close cooperation and open dialogue. The following are the conclusions of the mission. These will be elaborated in a staff report, to be discussed at the IMF Board in late summer.

Rome, June 11, 2002

Conclusions of the Mission

1. In the run-up to and following the creation of the European Monetary Union, Italy's economic performance has improved considerably: the fiscal accounts have strengthened; inflation has stabilized at euro-area levels; and employment has started rising after years of decline. In 2001, GDP growth was somewhat higher than in the euro area; inflation was moderate; and the fiscal deficit, while exceeding the original target, was less than 1½ percent of GDP—considerably lower than in France and Germany.

2. Nevertheless, the Italian economy continues to be hampered by structural weaknesses (including a large public debt and regional imbalances) that reduce its growth potential. Italy ranks only 18th in per capita income (in PPP terms) in the OECD. Steps to address these weaknesses are central to the policy strategy of the government elected in mid-2001.

Three challenges and a three-pronged strategy to meet them

3. Italy faces three key challenges:

• Raising employment: in spite of recent progress, Italy's employment rate is the lowest in the OECD—reflecting high unemployment and low labor force participation. Low employment is holding back per capita income: the Italian worker is highly productive, but comparatively few people work.

• Continuing fiscal consolidation: at almost 110 percent of GDP, the public debt ratio is the highest in the EU—and its service absorbs a correspondingly large share of taxes. Moreover, in spite of the reforms of the 1990s, aging-related spending (pensions and health care) is projected to rise substantially after the end of the current decade. As the Stability and Growth Pact (SGP) requires the debt ratio to fall if it exceeds 60 percent, Italy faces tighter constraints on fiscal policy than most other EU countries.

• Achieving high productivity growth as employment rises: productivity decelerated significantly in recent years, as employment picked up. The challenge is to achieve at the same time strong growth in both employment and productivity.

4. A three-pronged strategy is needed to meet these challenges:

• Labor market reform and complementary policies, including tax cuts, to stimulate labor demand and supply.

• Structural cuts in public spending, to strengthen fiscal consolidation and allow substantial cuts in the tax burden.

• Productivity-enhancing policies, including privatization, product market reform, and policies to further strengthen financial markets.

5. The government's bold reform program contains the key elements of such a strategy. An important theme of this program—and one that has received broad support from the social partners—is the emphasis on bringing to the surface the underground economy—which is outside the tax net and in which workers' basic rights are often violated.. The program also envisages a major simplification of the tax system, an important complement to reforms in other areas.

6. Progress has been made in implementing the government's program, but significant impediments have been encountered. This is hardly surprising given the extent of the vested interests that need to be overcome. However, rapid progress is critical if a turnaround in Italy's performance is to be achieved during the current legislature.

The macroeconomic outlook

7. Reforms have also been hindered by unfavorable international developments, which have depressed growth. The outlook is now improving. As elsewhere in the EU, the economic recovery began in early 2002, and should gain momentum in the second half of the year, helped by a pick-up in foreign demand, supportive monetary policy in the euro area, and the investment incentives of the Tremonti-bis. Reflecting this recovery, we project GDP growth around 1¼ percent in 2002, and 2¾ percent in 2003. Premised on continued wage moderation, inflation is expected to average just under 2½ percent in 2002 and to decelerate to1¾ percent in 2003. This growth outlook is subject to downside risks: world demand may be weaker than envisaged, and exports could also be affected by a sizable appreciation of the euro. Progress with the reform agenda would strengthen the economy's resilience.

Raising employment: labor market reform and complementary policies

8. Experience in the 1990s demonstrates that labor market and complementary policies can boost employment. Fast employment growth since the late 1990s reflects mainly two factors: wage moderation during the last decade, in the context of constructive relations among the social partners, and labor market liberalization measures since the mid-1990s. Liberalization of fixed-term contracts in 2001 is another positive step. To build on these achievements, further progress is needed.

9. As low employment in Italy reflects a host of factors, and not just one cause, reforms should rely on a broad-based strategy. Steps are needed to: (i) reduce the high tax wedge on labor; (ii) improve job training and matching, especially for new market entrants—but also for the elderly, to facilitate continued labor market participation; (iii) further relax employment protection legislation, and expand the role for arbitration to shorten dispute periods; and (iv) increase wage differentiation across regions. If properly designed, these steps would be particularly beneficial to the weakest segments of the labor market (notably women and the young). Labor market liberalization should be accompanied by reforms of Italy's insufficient unemployment insurance system—providing adequate income support for the jobless while safeguarding proper incentives for job search.

10. The government's labor market strategy is appropriately broad-based, and, although critical aspects remain to be decided, is moving forward. Social partners' support is important in this area, and the decision to engage them on the various interrelated aspects affecting the labor market (in the context of the four Tavoli) is welcome. At the same time, progress should be rapid and far-reaching, commensurate with the problems at hand.

11. Social partners should work towards wider wage differentiation across regions: national wage settlements have kept wage differentials too low when some regions experience full employment, while others struggle with some of the highest unemployment rates in the EU. Increased wage differentiation would raise labor demand in the formal economy, especially for lower skilled workers. Thus, we encourage the social partners to adopt more decentralized wage bargaining processes to reflect closely differences in productivity levels, local labor market conditions, and the cost of living. With respect to the latter, ISTAT should collect and publish comparable regional price level data. The public sector could play an indirect role in enhancing wage differentiation, by introducing, as in some other countries, regional cost-of-living allowances.

12. With unemployment concentrated in the South, well-designed development policies for the Mezzogiorno are also essential. The policy reorientation that began in the late 1990s is bearing fruit: output and employment have recently increased faster in the South than in the Center-North. Nevertheless, growth in the South remains below the government's medium-term targets. To meet these, continued efforts to strengthen administrative capacities and improve infrastructure are on the mark. Security problems and the slow pace of judicial proceedings in the South also warrant further attention.

Fiscal outlook and reform of taxes and public expenditure

13. Strong employment and output growth can benefit fiscal performance, boosting revenues and facilitating fiscal consolidation and tax cuts. In turn, the latter can stimulate growth, giving rise to a virtuous circle that has proved beneficial in a number of countries.

14. Proper sequencing of reforms is, however, critical. As the experience of other countries shows, it would be unwise to rely on uncertain supply effects or one-off measures to finance tax cuts. The latter must be perceived as sustainable to generate supply effects, and should thus be financed by structural expenditure cuts. Accordingly, it was appropriate to postpone substantial tax cuts to 2003; indeed, a further delay would be warranted if progress on expenditure reform remains elusive. Moreover, in assessing the room for tax cuts, fiscal projections should be based on an appropriately prudent growth outlook, taking into account new developments in a timely fashion.

15. On current trends, we project the Maastricht-based deficit (indebitamento netto) at 1¼-1½ percent of GDP in 2002, against a target of ½ percent. Some ½ percentage point of this slippage would be due to unfavorable cyclical developments. The rest would reflect structural expenditure slippages (notably for health care) and lower-than-budgeted revenues from some fiscal measures. This fiscal outlook, however, is surrounded by considerable uncertainty, partly because of a lack of quarterly data on the Maastricht-based deficit, in Italy as in other EU countries. Thus, different aggregates (such as the cash-based deficit, fabbisogno) must be used to evaluate fiscal trends. It would be useful if ISTAT worked towards publishing timely, quarterly data on the indebitamento netto.

16. Two additional features are important in evaluating recent fiscal developments:

• The 2001-02 deficits would be even higher in the absence of one-off revenues. Among these are: (i) those arising from tax measures that raise current but reduce future revenues (such as the tax on the revaluation of firms' assets); and (ii) proceeds from securitization (cartolarizzazioni) and direct asset sales. These operations help contain the borrowing requirement, and may have merits in themselves. But they do not amount to structural fiscal adjustment. Indeed, in the case of the securitization of lotto receipts higher revenues in 2001 will be fully offset by lower revenues in following years. Leaving aside issues of fiscal sustainability, the scarcity of information on the securitization operations may have given rise to undue concerns in the past. Hence, their transparency should be strengthened by publishing, in a user-friendly format, all relevant information, including any contingent fiscal liabilities.

• The fabbisogno is projected to remain, for a third year, well above the indebitamento netto. The April official projections anticipated a fabbisogno of 3¼ percent of GDP in 2002, and an indebitamento netto of ½ percent of GDP. The factors underlying the difference between these two aggregates are being assessed by the Biggeri Commission, and will be discussed in the context of the forthcoming IMF ROSC mission on fiscal transparency. In any case, it is the fabbisogno that matters for the growth of public debt. Thus, its evolution should be closely monitored, inter alia because the SGP requires that the debt ratio declines at a sufficiently fast pace whenever it exceeds 60 percent.

17. We welcome the authorities' continued commitment to balance the budget in 2003. This is appropriate in light of need for fiscal consolidation and, from a cyclical perspective, of the expected recovery of GDP growth to 2¾ percent. Automatic fiscal stabilizers should be allowed to operate symmetrically for growth deviations in 2003. It will be important to secure the deficit objective without undue reliance on one-off measures. In particular, should securitization eventually yield more than the currently envisaged ½ percent of GDP the fiscal balance should be correspondingly stronger.

18. Balancing the budget will require a determined effort to rein in public spending. Sizable savings are needed not only because of the likely fiscal slippage in 2002, but also to offset the loss of the 2002 one-off revenues and to make room for the planned tax cuts. On the positive side, the projected cyclical recovery will help, as it would support strong revenue growth. Structural spending reform, particularly for health care, should, in our view, be initiated in 2002, with a view to limiting the adjustment needed in 2003 and securing this year a clear decline in the deficit (net of asset sales) from its 2001 level.

19. Decisive steps are needed in all the areas that the government's medium-term fiscal plan (the 2001 DPEF) identified as requiring adjustment (such as public sector wage bill, pensions, and enterprise subsidies). The primary expenditure ratio is likely to rise this year. It is necessary to reverse this trend decisively in 2003:

• On the wage bill, hiring (especially at the subnational level) is undermining the government's plan of public employment reductions. It would be useful to integrate employment targets into updates of the Internal Stability Pact, and to secure moderate public sector wage increases in the future after the large gains of late.

• On social spending, reform steps (discussed below) should be initiated quickly to contain pension expenditure, even if they are unlikely to yield major budgetary benefits in the short-term. On health care, further action is needed to enforce regional spending ceilings and ensure consistency between regional expenditure obligations and resources. To contain demand, we see a case for expanding copayments, including by reversing the decisions taken ahead of the 2001 elections.

• On other current spending, room remains for cutting enterprise subsidies and outlays on other goods and services by building on recent advances in public procurement.

20. The government rightly sees tax reform as an integral part of its growth-oriented policy strategy. Important details remain to be determined. This is especially so for the personal income tax (IRPEF), with the incentive and distributional effects of the reform—and its revenue cost—critically dependent on the number, levels, and withdrawal rates of the allowances yet to be announced. To ensure simplification and increased transparency—key objectives of reforming the IRPEF—it is essential that the current extensive range of tax credits is not transformed into a similarly extensive range of allowances. The most pressing issue in this area is to reduce the tax burden on low income earners, thereby facilitating the employment of low skilled workers in the formal sector. In relation to business taxation, the reform of the corporate income tax, which began with freezing the dual income tax last year, is consistent with recent reforms adopted elsewhere in the EU. The consolidation provisions concerning the taxation of related firms offer the prospect of a useful rationalization of the current system. Further consideration might be given to the implications of the wide gap between the tax rates on companies and financial income. The third main area of reform is the phasing out of the IRAP. This, of course, should proceed only after it is replaced by alternative means of financing regional spending.

21. The mission welcomes the government's commitment to enhanced tax compliance, as part of its effort to bring to the surface the underground economy. Some results concerning delinquent social security contributors are encouraging, but the measure to facilitate the emergence of enterprises met limited success. More generally, schemes that condone past tax evasion (including the scudo fiscale), while possibly yielding short-term benefits, risk undermining the tax base through the expectation that they, or similar schemes, will be repeated. The mission advises against any steps that would nurture such expectations.

22. Public sector efficiency may benefit from the creation of entities managing public sector assets and infrastructure projects (Patrimonio S.p.A. and Infrastrutture S.p.A.). The potential pay-off from raising the yield on the large stock of public assets is clear. Equally clear is the difficulty of the task. With this in mind, it will be important not to overestimate the market value and yield on public sector assets. Regarding Infrastrutture S.p.A., the mission welcomes the government's intention that this new entity should provide credit only for economically viable (and self-financed) infrastructure projects. Careful preparation and monitoring should ensure that these objectives are met, and that future public sector liabilities are avoided.

23. Beyond 2003, a further strengthening of the fiscal balance would be prudent, at least until adequate progress has been made in reducing aging-related spending pressures and raising Italy's output potential. Absent major reforms of aging-related expenditures, the fiscal balance should be strengthened gradually to levels already achieved in several EU countries. This would be necessary because, notwithstanding the reforms of the 1990s, pension spending is still projected to rise substantially from a level that is already among the highest in the OECD. On the other hand, early progress on pension reform would alleviate the need for sizable fiscal surpluses, creating room for additional tax cuts. Such reforms should aim to raise the average retirement age and shorten the transition to the contribution-based pension regime. The government's plan to use the present severance payment system (TFR) to build a second, fully-funded and private pension pillar is welcome.

24. Over the medium term, the fiscal accounts will critically depend on proper coordination between different levels of government. The economic role of regions and municipalities has expanded in recent years, a process that has gained momentum following the 2001 constitutional reform. In this environment, experience in other countries highlights the importance of strong policy coordination among different levels of government and of adequate enforcement mechanisms for fiscal discipline. In this respect, we welcome the recent resolution of a parliamentary committee calling, inter alia, for better rules for the implementation and monitoring of the Internal Stability Pact.

Structural reforms to enhance productivity growth

25. Product market and financial sector reform can yield synergies with reforms in other areas, and raise productivity growth. Enhanced competition can strengthen the incentives to innovate and invest in research and development, and ensure that the benefits of labor market reform are fully and equitably realized. In this respect:

• We welcome the recent work of the privatization committee, which should reinvigorate privatization. It will also be important to set in place proper incentives to speed up the privatization of the extensive properties owned by local governments.

• Plans to separate ownership of electricity transmission from production assets are also to be commended. Effective competition in the electricity market will, however, require extra divestiture of the dominant firm (beyond the third generator company), and an easing of restrictions on its market share thereafter. In the natural gas sector, divestiture of the dominant firm is also the key issue for strengthening competition.

• The effectiveness of central guidelines to raise competition in local public service provision remains uncertain. Improved implementation requires better coordination between different levels of government—a need illustrated by insufficient progress in achieving more competition in retail trade. Giving additional sanctioning powers to the Anti-Trust Authority could foster competition in the professional services sector.

• It is hoped that long overdue reforms to the bankruptcy law—to better protect the value of firms in difficulty, and reduce resolution costs—will proceed in a timely fashion.

26. The strengthening and expansion of the financial sector has been remarkable over the past decade. In 2001, the reversal of the downward trend in the banking system's capital ratio—despite sizeable negative shocks to banking profitability—is reassuring. This change was fostered by the Banca d'Italia establishing capital ratio targets well above minimum international standards, and was apparently achieved without a significant impact on credit growth—which has slowed in line with weaker economic activity. Legislative changes to preclude the control of financial institutions by non-profit foundations should improve governance, but implementation details will need to be carefully considered to make sure that the relationship between foundations and asset management companies (SGRs) is truly at arms' length. Further steps are needed to raise the protection of minority shareholders and strengthen corporate governance—including facilitating shareholders' intervention at shareholder meetings, and proceeding with plans to improve disclosure, especially for unusual and related party transactions.