IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
This paper is excerpted from the forthcoming "IREF’s Yearbook on Taxation" 2012
On July 6 the Berlusconi government passed a first package of mandating modest immediate cuts in the expenditure and similarly modest immediate increases in tax revenue to address concerns on the capacity of Italy to serve its huge public debt. Because this was not enough to reassure markets, the government had to pass a second, more substantial, package of fiscal measures on August 13. Despite those packages and the drafting of a constitutional amendment requiring balanced budgets, Berlusconi’s government had to go off the stage and the new Monti’s team immediately introduced a third package. As a result, Italy probably never experienced since the tax reform of the 1970’s such a huge number of changes in its tax system. Changes refer both to the introduction of new taxes and to modification of tax rates and of the tax base of the present taxes.
The year 2011 has been full of economic, financial and political events in Italy. Fueled by the dramatic deepening of the financial crisis in Greece and then in Portugal and Spain, investors’ concerns on the capacity of Italy to serve its huge public debt brought, in the early summer, the spread between the German and the Italian bonds to unprecedented levels. The government response was initially rather modest and, above all, it was intended to reach the balance in public sector budget not before 2014. On July 6 the Berlusconi government passed a first package of measures (Decree Law 98/2011) mandating modest immediate cuts in the expenditure and similarly modest immediate increases in tax revenue. The reluctance of the government to restructure the public finances brought to a deepening of the crisis of financial markets with a further widening of the spread and to a sharp fall of stock markets all over Europe. Banks’ shares were severely affected showing investors’ worries on the capacity of the banks to sustain huge losses in their assets brought up by the collapse of the price of Italian and other European bonds. The government was hence forced to pass a second package of fiscal measures on August 13. Correcting measures, both on the expenditure and the revenue front, were more substantial than those of July, but they were still not deemed to be enough by investors.
Two draft constitutional amendments were also presented. The first one was aimed at enshrining in the constitution the requirement of balanced budget. The second amendment mandated the suppression of the provinces and their replacement with associations of municipalities.
The diminished personal image of the prime minister, due to his numerous “controversies” with the justice and the media, contributed to the rapid shrinking of the confidence of investors in the government. In the late fall, the Berlusconi government stepped down and was replaced by a “technical government” led by Professor Mario Monti and supported by a large, although quite composite, parliamentary coalition. The first and immediate task of the new government was the introduction of a third package of fiscal measures on December 6 (decree law 201/2011 ratified as law 214/2011).
The total impact of the Monti’s package for 2012 is approximately equal to the combined impact of the two Berlusconi’s packages, while the impact for the following years of Monti’s measures is considerably smaller than that of the Berlusconi’s combined packages. More precisely, according to the Bank of Italy estimates – shown in Table 1– the total impact for 2012 of the Berlusconi’s packages on net borrowing will amount to 1.8 per cent of GDP, while the Monti’s package is estimated to impact for 1.3 per cent. For 2013 and 2014 the corresponding figures are 3.3 and 3.5 per cent for Berlusconi and 1.3 and 1.3 per cent for Monti.
Towards the end of the year the situation of financial markets eased showing that Italian authorities were inspiring greater confidence to investors. This is due to the combined effect of the packages and to the perceived higher commitment/ability of the technical government to ask substantial sacrifices to the population. However, the situation remains quite unstable and volatile.
Table 1. Italy: The combined effect of the 2011 finance packages on net borrowing
Source: Bank of Italy, Economic Bulletin, n.63, January 2012
Budget policy results and perspectives
The three fiscal packages of 2011 brought a small reduction of the borrowing requirement of the central government to 3.9 per cent of GDP; down from 4.3 percent of the previous year. Preliminary data indicates that general government net borrowing also declined with respect to 2010, from 4.6 per cent of GDP to 3.8 per cent. The result reflects a fall in total expenditure in relation to GDP, despite the increase in interest payments, accompanied by a basically stable ratio of revenue to GDP. However, due to the stagnation of the economy and the rising cost of interests on public debt, the incidence of the latter on GDP has continued to increase - by about 1.5 percentage points from 118.6 percent to 120.1 percent – feeding investors’ worries on the capacity of Italy to sustain the burden. The three budget packages approved in the second semester of last year should contribute to a significant improvement in the public finances over the next three years. Their impact on net borrowing is officially estimated at 3.0 percentage points of GDP in 2012 and at 4.7 points a year in 2013 and 2014. The expenditure measures will bring a reduction of 1.6 percentage points of its share of GDP in 2014; significant savings will derive from the measures concerning pensions, which will produce their full effects over a longer time span.
Table 2. Italy: Basic fiscal data
Main sources: Ministero dell’Economia, Economic and Financial Document; Combined Report on the Economy and Public Finance; Bank of Italy. Economic Bulletin, various issues.
Possibly, Italy never experienced since the tax reform of the 1970’s such a huge number of changes in its tax system. Changes refer both to the introduction of new taxes and to modification of tax rates and of the tax base of the present taxes. The overriding goal was to provide quick increases of collections with some consideration to the equity impact of the measures. Some measures are, in principle, temporary and should be retracted with the improvement of the overall budget conditions.
There are similarities, but also important differences between the policies pursued by the two governments that alternated into power. The main similarity is the high reliance in both cases on indirect taxes: VAT and the excise on fuel. With reference to the latter, Italy is now experiencing one of highest burdens on gasoline and fuel. The main differences between packages refer to direct taxes. The two Berlusconi’s packages focused on income taxes paid both by companies and individuals. Concerning companies, the changes have been the increase of the burden put on energy companies and banks. For individuals, there has been an increase of taxes on financial revenues and a temporary increase of the top rate on the personal income tax as well as an equally temporary “solidarity contribution” on very large-sized pensions.
The Monti’s package is more focused on wealth taxation. It includes the reintroduction of the municipal property tax on primary residences along with a restructuring of the tax. It also includes a tax on real property held abroad and a renewed levy on financial assets repatriated in the past years (the legal ground of this levy is, however, quite shaky, since it reneges a previous contract between the State and taxpayers who repatriated their assets). Finally, the Monti’s package has more elements of certainty referring to the actual flow of tax payments being based on measures with immediate effect, while Berlusconi’s package rely on the fight of evasion and on closure of loopholes, whose actual impact on tax payments is more potential than real. This explains, among other reasons, why the reaction of financial market to the tax packages of the two governments has been different.
Table 3. Main tax changes introduced in July- August 2011 (Berlusconi’s government)
Main source: Bank of Italy. Economic Bulletin, various issues
Table 4. Main tax changes introduced in December 2011 (Monti’s government)
Main source: Bank of Italy. Economic Bulletin, various issues
Tax changes have been many and substantial. They will bring an important increase of tax revenue unless the Italian situation deteriorates rapidly. The tax pressure is going to increase hugely reaching unprecedented levels for Italy—from 42,2 % in 2011 to 45,3% in 2012—nurturing a strong reaction by taxpayers, which is already being manifested. Being dictated by urgency of revenue, the tax changes have further distorted the Italian tax system, increasing the number of tax instruments used and possibly the overall inconsistency. Clearly, an overall reform is needed, but it could be delayed by the precarious economic and financial conditions of the country.