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Reforms Key to Italy's Efforts to Outgrow Crisis

Worker checks a motorbike on an Italian production line. Exports are expected to lead a recovery in Italy’s economy from next year (photo: Alessandro Ruggeri/AFP)

ITALY ECONOMIC REVIEW

Reforms Key to Italy's Efforts to Outgrow Crisis

IMF Survey online

July 10, 2012

  • Prompt and consistent implementation of wide-ranging reforms needed to revive growth
  • Outlook remains vulnerable, with key risks stemming from euro area crisis
  • Progress in creating more integrated euro area will be crucial for securing stability

While fighting contagion from the euro area crisis, Italy is currently engaged on several fronts to restore stability and growth to its economy.

The government is seeking to maintain the momentum of reforms to address the economy’s deep-seated structural weaknesses and lock in medium-term fiscal targets to further improve market confidence.

In an interview with IMF Survey magazine, Kenneth Kang, the IMF mission chief , and Lusine Lusinyan, one of the desk economists for Italy, discuss the findings of the IMF’s annual assessment of Italy’s economy and the challenges of reviving growth—a crucial component for Italy’s outlook—while maintaining fiscal sustainability in the midst of the eurozone crisis.

IMF Survey: Italy’s fiscal consolidation for 2012-14 will be around 5 percent of GDP. Despite this strong effort and generally good economic fundamentals, Italian sovereign debt spreads have widened relative to, say, a year ago. What is the IMF’s assessment of Italy’s economy?

Kenneth Kang: Italy is implementing an ambitious agenda of fiscal and structural reforms. Despite these efforts the country remains vulnerable to the euro area crisis. The imperative now is to revive growth, and for this our policy recommendations are to implement reforms to close the competitiveness gap and to raise productivity; focus on growth-friendly fiscal consolidation; and to strengthen the financial system.

The focus on structural reforms is especially important since the Italian economy will continue to contract this year, owing to tight financial conditions, necessary fiscal consolidation, and the global slowdown. On this basis, we project growth to decline by about 2 percent in 2012 and a mild recovery to begin sometime in early 2013, led by a modest pickup in exports, which would spill over and gradually lift household spending and business investment.

The planned fiscal adjustment is indeed sizable. The government’s primary balance, which excludes interest payments, is forecast to reach 4 percent of GDP by next year—the highest in the euro area. This will help stabilize Italy’s large debt-to-GDP ratio next year and put it on a downward path over the medium term.

Last but not least, the government has taken the important step of adopting a constitutionally mandated budget rule for achieving structural fiscal balance, which will take effect in 2014.

Strengthening the tools and institutions that will support the fiscal rule, such as the medium-term expenditure framework and the independent fiscal council, will help lock in these impressive fiscal gains and strengthen budget discipline.

IMF Survey: Your report talks about growth-friendly fiscal consolidation. How can this be achieved?

Kang: In Italy, fiscal adjustment is taking place mainly on the revenue side. Shifting the composition of adjustment to cutting government expenditure and lowering taxes would help spur growth.

To this end, we place a high priority on the ongoing expenditure review to cut inefficient expenditure and generate savings that will allow taxes to be lowered—let’s not forget that taxes are far higher in Italy than in other OECD countries.

Other growth-enhancing measures could include reducing the labor-tax wedge, increasing the allowance for corporate equity to promote investments, and a modest, but well-targeted, investment in public infrastructure.

IMF Survey: The staff report suggests a fiscal devaluation. Can you explain what it is and whether it would be feasible in Italy?

Kang: A fiscal devaluation is essentially a revenue-neutral shift away from employers’ social security contributions toward the value-added tax. This shift is designed to boost growth, employment, and exports by reducing tax distortions, increasing demand for labor, and improving competitiveness.

At the IMF, we have looked at the impact of fiscal devaluation on growth. In the case of Italy, a 2 percent of GDP shift from social security contributions toward value-added tax could lift the level of GDP and employment by about 1 percent over the long run. In addition, the cut in social security contributions could be targeted at lower wage levels to reduce the cost of the measure, but also to benefit low earners, women, and young workers.

There are a number of reasons why fiscal devaluation might work well in Italy: its high labor-tax wedge, wage rigidity, and the fact that the fixed exchange rate covers a large proportion of trade. Fiscal devaluation would facilitate the wage and price adjustments needed to restore Italy’s external competitiveness in the absence of an exchange-rate adjustment.

IMF Survey: Are you suggesting an increase in the value-added tax to lower social security contributions?

Kang: No, we are certainly not proposing to raise the value-added tax rate, which is already relatively high in Italy compared to other OECD countries.

But we are proposing to broaden the tax base. With tax deductions, credits and special allowances very high in Italy, there is scope to reduce these so-called “tax expenditures” to generate savings to lower taxes elsewhere.

IMF Survey: The IMF is forecasting substantial gains from deeper structural reformsamounting to a boost to GDP of almost 6 percent over the next 5 years. Are the recent product and service market liberalization reforms sufficient to jumpstart growth?  

Lusinyan: In the last decade, growth in Italy averaged less than percent against an average of over 1 percent in the EU. In addition, total factor productivity growth was negative. Many factors have contributed to this poor performance, not least key bottlenecks in the product and labor markets.

The liberalization reforms that were introduced in 2012 are wide-ranging, and address the energy and transportation sectors, professional services, local public services, but also, importantly, the framework for enforcing competition rules in Italy.

Whether these reforms will suffice to put Italy on a higher and solid growth path depends very much on implementation. If we assume that the continuous implementation of these reforms could close about half the gap with the best practice cases in product market competition and labor market efficiency and participation, these reforms would produce a sizable increase of GDP—around 6 percent—in the medium term.

IMF Survey: You outlined some ideas for reform in a selected issues paper that accompanies the staff report. Can you summarize for us what these reforms are, and how these concrete gains can be achieved?

Lusinyan: Combining simultaneous product and labor market reforms would maximize the effects of reform on output and improve growth substantially in the medium term.

Italy is essentially a service-oriented economy; services represent over 70 percent of GDP. Estimates suggest that prices of services (nontradables) in Italy could be about 60 percent higher than in case of a perfect competition in the markets; this markup is estimated at about 35 percent elsewhere in the euro area.

So, reducing markups and improving competition would lower tremendously the cost of doing business and ultimately translate into lower costs for the customers.

Not only will implementation of the reforms be critical, but it should also be accelerated in those areas that can have the largest and broadest impact. Let’s take the energy sector. Electricity prices are 50 percent higher in Italy than the European average, especially for industrial users. Reforms that will promote competition in the gas sector would benefit the entire economy. The separation of the gas distributor and gas production company needs to be completed swiftly.

Similarly, it would be critical to liberalize professional services, which represent about 10 percent of all the total costs for businesses in Italy.

Finally, compared to the authorities’ program, more could be done to privatize both assets and utilities at the local level. Some recent steps have been taken in this area, but we think a more comprehensive approach could help improve the efficiency of the public sector.

IMF Survey: What impact do you expect from the recently agreed labor reform? How do you respond to those who claim that a more flexible labor market will only undermine job security for all without really creating new jobs?

Lusinyan: Reforming the labor market in Italy is crucial to reviving growth through increased productivity but also to address equity concerns more broadly. Italy has a segmented, dual labor market, characterized by highly-protected group of “insiders” and a large cohort of younger workers, who move from contract to contract.

The government’s plans go in the right direction by giving incentives to hire on an open-ended basis to increase job security for all, and lowering the cost of hiring and firing. While there could be some temporary short-term costs as workers are allocated to new growth industries, over time, a more competitive and dynamic labor market will benefit the entire country, and especially young Italians.

However, more could be done to move away from using a variety of temporary labor contracts to a single more flexible contract with phased-in protection that increases with tenure; and to boost participation in the labor force.

On the latter, participation rates are extremely low, especially among women at 50 percent compared to 65 percent in the rest of the European Union.

In addition to child-care and maternity support measures envisaged in the current reform, the government could consider reducing the marginal tax rate for second earners.

IMF Survey: Your report also assessed the health of the financial sector. What are your conclusions?

Kang: The Italian banking system has many positive features: it has a large and stable funding base and has low leverage relative to other banking systems in Europe. But the banking system also faces a number of risks.

Non-performing loans have been rising, leaving the banks vulnerable to the economic slowdown. Italian banks have also been facing market pressures and continue to rely heavily on the Eurosystem for financial liquidity support. Our recommendation is to continue with the plans to increase capitalization, to make sure that banks have enough capital to support lending activities in Italy.

We also see the need to provide the basis to write down non-performing loans as quickly as possible so that banks would have room for lending.

IMF Survey: You say that Italy’s success also depends on progress at the European level. How will Italy benefit from the recent decisions taken at the EU Council?

Kang: Securing macroeconomic stability and providing growth in Italy will depend not only on maintaining a good momentum for reforms in Italy itself, but also on greater progress at the European level in strengthening the currency union. The recent moves to deepen fiscal integration and create a more vibrant banking union will help to that end.

In addition, as the staff report mentions, enhanced coordination at the EU level in promoting a single market for services, transport, and energy, as well as greater investment under a growth compact, will also support Italy’s efforts in these areas.