IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
Moody’s rating agency warned on Friday on Italy’s public debt and mentioned the reviewing of Italy’s credit rating for a possible downgrade. This change, if it happens, would increase the government’s borrowing costs and have a very negative impact on public finances.
Italian economy struggles to recover from the crisis. GDP growth remains among the lowest in the euro area and has been slowing down during the past year. According to recent estimates by the Bank of Italy, GDP growth has been in the order of 1.0 per cent in 2010, will stay the same in 2011 and will slightly increase to 1.3 per cent in 2012.
The main impetus to economic activity continues to come from exports, but the international competitiveness of the Italian economy remains insufficient and there are no government efforts to improve it. The contribution of domestic demand remains not only modest, but has even diminished in connection with the slowdown in investment in machinery and equipment following the termination of tax incentives. Households’ spending continues to be governed by caution, in view of the weakness of disposable income and the bleak perspectives about resumption of employment. A good fiscal stimulus through tax concessions would greatly help, but it is presently incompatible with EU regulations and with the present situation of the Italian public finance.
In 2010 tax revenue recorded in the state budget fell by 1.0 per cent. The fall is mainly due to the expiration of the foreign assets disclosure scheme that had been introduced the previous year and that had contributed in a substantial, although temporary way, to revenue collection. A factor of opposite sign was the postponement of receipts to 2010 as a result of the temporary reduction in the percentage of the personal income tax payment on account due at the end of 2009. Personal income tax receipts, buoyed by that measure, rose by 4.5 per cent. VAT receipts registered relatively high growth of 4.6 per cent, fuelled particularly by those from imports, while receipts from flat-rate withholding taxes on income from financial assets fell significantly, by 42.5 per cent, due to the fall of dividends (particularly from banks) and to the generally very low rate of interest on bonds and other fixed income instruments and those from excise duties decreased by 5.7 per cent.
The government has also tried to contain expenditure operating in the two areas: sub-national finance and social protection, where there still is some substantial meat” to cut. More specifically, Regions, Provinces and Municipalities are required to reduce significantly their expenditure following a substantial cut to grants to them. A significant contribution is also expected from the measures regarding social security, which are expected to produce progressively larger savings over the three years. In particular, these measures concern: the postponement of the starting date for pensions that mature after 31 December 2010 (setting the interval between the retirement date and the payment of the first monthly instalment equal to 12 months for employees and 18 months for self-employed workers); the payment of public-sector severance pay in excess of €90,000 by instalments (in two or three annual payments depending on whether the amount is less or more than €150,000); and the tightening of checks on disability pensions and of the requirements for eligibility for such assistance. The government has also mandated cuts in the spending of Ministries by reducing budget appropriations by 10 per cent, including on capital account, which reduce expenditure by €2.1 billion on average per year. Major adjustments are also made to the compensation of better-paid employees in the public sector with cuts amounting to €1.4 billion on average per year. This result derives from the freezing of individual pay at the 2010 level, the extension to 2012 and 2013 of the 20 per cent limit on the replacement of departing staff in central government (excluding the police forces, firemen and university teachers, to whom less stringent limits apply), and the postponement to 2011 of the effects of the reorganization of careers in the security sector and the armed forces. Provision has also been made aimed at reducing pharmaceutical expenditure, primarily by reducing the margin of wholesalers and pharmaceutical companies.
As a result, the deficit of the public sector has been contained. More precisely, the ratio of net borrowing to GDP fell in the first three quarters of 2010 compared with a year earlier by 0.4 percentage points to 5.1 per cent. It has also to be mentioned that primary expenditure decreased by 0.4 per cent: capital expenditure contracted more sharply, by 18.2 per cent, while primary current expenditure expanded by 1.2 per cent due to the growth of 2.4 per cent in social benefits. The available information suggests that net borrowing in 2010 should be lower than expected and should contract further in the following years. Despite all these efforts the ratio of public debt on GDP continues to rise, given the practical immobility of the denominator of the ratio.
Italian public finances are still in a precarious state that could worsen abruptly should the world economy recovery and monetary policies lead to an increase of interest rates.
This article is extract from IREF’s Yearbook on European Taxation 2011