Italy’s draft budget: a costly stimulus that lacks structural reforms
In mid-October, the Italian M5S-Lega coalition government submitted its 2019 draft budgetary plan to the European Commission, which subsequently rejected it on 23 October in what is called in Brussels’ jargon an opinion. The rejection of the Italian draft budget by the Commission, on the grounds that it would increase the budget deficit too much, was unprecedented. According to the plan, the Italian deficit would increase from a previous target of 0.8% to 2.4% of GDP in 2019. While this is in compliance with the 3% ceiling imposed by the Maastricht Treaty and less than the 2.8% planned by France, such a deficit would undermine the progress that Italy should make towards reducing its public debt, which stands out at currently 131.4% of GDP, more than twice the 60% debt benchmark.
In this blog we examine why the Commission objected to the Italian budget draft, but not the French 5-year plan presented last year. We show that the Italian budget is a costly stimulus that lacks substantive structural reforms.
The structural adjustment required is computed by the Commission in terms of a short-term effort (the EC Recommendation) and a medium-term objective (MTO). As can be seen in figure 1, Italy’s plan would lead to a structural worsening of its budget balance by 0.8% of GDP, compared to a recommendation of an improvement of 0.6% of GDP next year and a medium-term objective of budget balance. By comparison, France’s draft budget presents a modest but positive structural adjustment: it plans a structural budget improvement of between 0.2 and 0.3%* of GDP, which is also lower than its recommendation of 0.6%.
Figure 1: Comparison of Italian and French budget plans for 2019
Source: European Commission
Italy now has a couple of weeks left to choose whether to amend its draft budgetary plans or to disregard the EU’s warnings. If the government sticks to the current proposal, after another three weeks, the Commission could bring Italy back under the EU Excessive Deficit Procedure (EDP), and that could imply facing sanctions of up to 0.5% of GDP. The irony is of course that sanctions would further deteriorate Italy’s budget rather than put it back in line. In the meantime, the yield on the benchmark 10-year sovereign bond has risen to an almost 4-year high while Moody’s has downgraded the rating for Italian debt.
Looking at the 2019 budget as it is now, the key policies are the scrapping of the previously planned VAT hike for 2019, the introduction of a minimum citizenship income and the partial unwinding of the 2012 pension reform. The so-called 'flat tax' at 15% will only apply to SMEs – which as such will have a limited budgetary impact - and finally additional government investment will amount to some 0.2% of GDP. There are planned spending cuts, worth about EUR 3.5bn, together with a 'tax amnesty' set to raise less than a third of that.
Table 1: Main fiscal measures in Italy for 2019
Source: Italian Ministry of Finance
It is telling to compare the proposed Italian budget with the 2017 fiscal reform in France which aimed at improving the economy’s medium-term growth prospects and reducing the budget deficit. In the November 2017 NIESR Ecoomic Review, we simulated the effects of the fiscal package, consisting of two broad measures: reduction in taxes by 1 per cent of GDP and reduction in public spending by 3 per cent of GDP within 5 years. Our analysis suggested that the fiscal package has the potential to stimulate the supply side of the economy significantly. According to our simulations, in the short term, the consolidation in public spending almost completely offsets the positive effect of tax cuts and increased investments. However, the structural shift towards lower taxes and lower public expenditure would significantly improve growth prospects in the medium term, once the fiscal consolidation is over.
Looking at the potential effects of the draft budget in Italy as it is now, the mix of policies presented does not seem likely to achieve a substantial boost to growth, in particular considering the supply side, which affects potential output growth in the long term. Excluding the VAT hike repeal, and even if we disregarded the contractionary measures included in the budget, most of the stimulus would be delivered as social transfers, which we think have a multiplier of about 0.5, and pensions, with a multiplier close to zero. Also, there is relatively little on investments.
What is more, back in June, we showed that the economic boost that a potential fiscal stimulus is meant to provide to the Italian economy would likely be offset by the reaction in financial markets due to the clash with EU fiscal rules and concerns for its debt sustainability. Higher sovereign yields, if sustained, will increase corporate financing costs, which would adversely affect investment spending and domestic demand growth.
* EC computation gives 0.2% and French government computation gives 0.3%