VoxEU Column Europe's nations and regions

Delirium Tremons

Italy may be headed for recession. The government's fiscal position would allow it to use prudent tax cuts to prevent recession, but its new budget plan only signals trouble.

We are living difficult times. Inflation is up and running. The United States has been hit by three simultaneous shocks – the new oil shock, the stock market crash, and the fall in housing prices – and hence the recession seems unavoidable. It will be a new US stagflation 30 years after the first.

Europe is in a slightly better position thanks to the euro appreciation, which mitigates the oil price hike. But Italy is far more vulnerable than the other economies of the Old Continent because it has been stagnating in the last 15 years. Italian income per-capita fell below not only the EU-15, but also the EU-19 average (including also Czech and Slovak Republics, Hungary, and Poland). Real incomes of Italians have been flat as Holland in the last decade. Wages of Italian workers are now 30% to 40% lower than those of their French or German counterparts. And Italy has no safety net protecting those hit under a recession.

How to avoid a recession in Italy

Under these conditions, the primary task of economic policy should be to use all the available instruments to enabe the economy to avoid a recession. Due to high debt, there is not much room for countercyclical fiscal policies in Italy. However, tax revenues have been particularly buoyant in the last three years thanks to a successful policy of repression of tax evasion. Moreover, under high inflation, Italy’s strongly progressive tax schedule pays to the Government a large dividend from the “fiscal drag” (shifting individuals to higher tax brackets even if their real incomes do not increase). According to our estimates (see www.lavoce.info), the fiscal drag in this current fiscal year could be more than €4 billion.

The most sensible thing to do would be to use this money to reduce taxes on labour. This would have an expansionary effect on demand (consumption has been declining in real terms lately!) as well as on supply. Indeed labour costs would fall as well and part of the huge Italian non-employment could be absorbed. A simple way to cut labour taxes would be to increase tax deductions for workers. The rationale for these deductions is, after all, to compensate workers for the costs incurred in generating their incomes and transportation costs, which have increased dramatically due to the rise in the price of fuel.

Berlusconi’s plan: Rising tax receipts

Rather than cutting taxes on labour, the Italian Government just approved a five-year budget plan (the DPEF, Documento di Programmazione Economica e Finanziaria 2009-2013) that envisages no reduction in tax pressure. Actually, tax revenues as a proportion of GDP are supposed to increase slightly from 43% to 43.2% in 2010. Besides betraying voters – who were promised a reduction of tax pressure bringing it below 40% – this scenario gives us little hope of avoiding a recession.

Alternative ideas for fiscal consolidation

The only way to support the economy while completing the fiscal consolidation would be to cut public spending by reducing the widespread wasting of resources. To give an example, Italy spends more that an average EU country for education, but pupils have scores in international tests (such as PISA, Programme for International Students Assessment) that are significantly lower than the EU average. Moreover, the Italian regions with the lowest PISA scores are precisely those where expenditure per student is larger and teachers are paid more in real terms. This means that it is possible to cut spending without reducing the quality of education, or it is possible to improve the quality of education without increasing public spending.

Another area where large savings are possible while actually increasing the quality of public services is fiscal federalism. About one fourth of the Italian budget goes to transfers to regions and local administrations. The fact of the matter is that fiscal federalism is based on a decentralisation of spending capacity and a centralisation of tax revenues. This is a recipe for losing control over local spending, as voters do not consider regional administrations responsible for the taxes they pay.

Italian fiscal consolidation will instead continue to occur on the revenue side rather than via targeted spending cuts. This is the depressing message delivered by the five-year budget plan, deciding the stance of economic policy for the entire legislature.

Meanwhile, in order to “reassure” frightened Italians saving on the purchase of even staples such as bread and pasta, Giulio Tremonti is literally seizing the day to predict gloomy scenarios. We are falling into a new Great Depression, he claims, whenever he gives a public speech (a rather frequent event), due to the devils of globalisation and the presence of China in the WTO. For the electoral campaign, Mr Tremonti wrote a book titled The Fear and the Hope. Unfortunately he seems to have forgotten about the second part of the title now that he is in power.

Editors' Note: A version of this first appeared in WSJ Europe.