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Italy Fiscal October 2019

Italy: A patchwork budget and timid fiscal expansion fail to address Italy’s structural problems

On 15 October, the new government formed by the Democratic Party (PD) and the Five Star Movement (M5S) submitted the draft 2020 budget to the European Commission (EC) for approval. The budget revealed a fiscal deficit that was slightly higher than originally agreed upon, as was broadly expected by market analysts. Notably, it scraps a planned VAT increase, which would have likely hit consumer spending, and also reduces the tax wedge for low-to-middle income earners, which should provide some economic support in the short-term. It proposes to finance these measures chiefly through interest-payment savings and the war waged against tax evasion. However, there is a great deal of uncertainty over how much additional revenue the crackdown will realistically generate, while the lack of any serious attempt to address public spending and improve the business climate leave Italy’s structural problems unaddressed.

The government’s 2020 budget projects a budget deficit of 2.2% of GDP in 2020. While this is higher than the 2.0% of GDP agreed upon with the EC last July, the EU institutions are expected to adopt a conciliatory approach due to the new government’s more Europhile stance. The public debt-to-GDP ratio is also projected to decline, albeit only marginally, from 135.7% expected this year to a still sky-high 135.2% in 2020—and is seen on a downward path thereafter. On top of the increase in the fiscal deficit projection, the government had to find new revenue sources to substitute the VAT hike. Estimates of additional revenues from the fight against tax evasion account for the lion’s share of the financing sources; however, the majority of analysts consider the projected savings of 0.4% of GDP overly optimistic. Some reduction of allowed tax deductions, the introduction of a plastic tax and a myriad of increases in specific taxes—such as in the leasehold excise tax and the winning tax—complete the picture. Meanwhile, the tax wedge reduction should leave more money in the pockets of consumers. It is uncertain, however, whether this will translate into higher spending or rather into additional precautionary savings given the current economic climate.

The overall economic impact of the budget will be quite muted. The economy could receive a small boost in the short-term, but concerns over the sustainability of the country’s public finances and its lackluster performance could cause households to hoard money instead of spending it. Moreover, the budget fails to address Italy’s long-standing problems including the second-highest public debt-to-GDP ratio in the European Union, sluggish productivity growth, high public spending, elevated taxes and its cumbersome bureaucracy. The economy is thus set to gain only limited steam in 2020, on the back of an uptick in domestic demand and a recovery in the industrial sector. And Italy will consequently continue to be the growth laggard in the EU, with weakening employment dynamics and muted productivity gains limiting consumer spending, and subdued credit growth and an unfavorable tax regime restraining business investment. Furthermore, political uncertainty, the huge public debt burden and resurging financial turbulence pose significant downside risks.

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