Global Insight Perspective

Significance

Prime Minister Romano Prodi and Economy Minister Tommaso Padoa-Schioppa have spent recent days defending the agreed draft 2007 budget.

Implications

The "compromise" they claim to have found will, on paper, reduce the public deficit to meet Eurozone criteria. In the short term, gaining parliamentary approval for the budget will be a test for the government; in the long term the challenge will be meeting the targets, under the watchful eye of the European Commission.

Outlook

Prodi will be reliant on the upper house of parliament for approval of the draft, and until then ratings agencies remain circumspect with regard to the outlook for public finances. The life senators that have backed the government in recent months could prove crucial to getting the draft approved. Threats of public protests from the opposition are mistimed and should present no risk.

The draft 2007 budget approved by the government in recent days has attracted criticism, forcing Prime Minister Romano Prodi to defend its provisions, describing the package as a "good compromise". He also said that it should reassure ratings agencies, which have considered downgrading Italian ratings as public finances have progressively worsened in recent years. Prodi has placed the blame for this squarely on the shoulders of the previous centre-right government of Silvio Berlusconi, and along with Economy Minister Tommaso Padoa-Schioppa has gone on a public-relations offensive in recent days in an attempt to provide reassurance.

The public debt level is expected to rise to around 108% of GDP by end-2006, but is slated to fall to 106.9% by end-2007, and the budget deficit will be cut in line with Eurozone requirements to 2.8% of GDP. The deficit has risen above the 3%-of-GDP ceiling stipulated by the European Union (EU) rules for the last three years, and Global Insight expects it to rise to 4.3% of GDP this year, despite the emergency budget passed following April’s elections. The 2007 budget sees 20 billion euro (US$25 billion) in cuts to expenditure and 13.4 billion euro gleaned from revenue-raising measures. The full details of the proposals haves not yet been revealed, but the draft will shortly be submitted to parliament.

Gaining agreement on the budget in the cabinet and governing coalition was no mean feat, considering that it had to satisfy the interests of nine different parties, and that the left-leaning coalition's desire for looser fiscal policy to allow higher education, health and pensions spending was incompatible with the need to rein in debt levels. According to the draft, health spending will be cut by 3 billion euro, and pension funding by 9.5 billion euro. However, the final proposals have been welcomed by unions, with the largest saying that their demands have been met,.

A Useful Compromise?

Businesses have criticised parts of the draft, and others have questioned the logic of tax increases for high earners, which will result in only a sliver of additional revenue in the midst of tax cuts for swathes of middle earners. Businesses also object to the proposal to siphon off part of funds established for severance pay into the INPS state pension funds (which will account for around 5 billion euro of the pension funding reductions). Influential business organisation Confindustria called the proposal "robbery". This, and the insistence on an increase in capital gains tax from 12.5% to 20% on some securities, has proved unpopular. However, business-friendly proposals are also included, such as a 10% tax break for firms investing in research. Payroll taxes are due to be cut—an election campaign promise—as part of measures to help increase the competitiveness of the economy. These cuts will occur in February and July, at a cost of around 9 billion euro, according to Schioppa. Businesses feel though that the draft does not go far enough. The announcement last month that better growth in 2006, and thus additional tax receipts, would allow spending cuts to be moderated raised concerns that the government would shy away from its promise of hard-hitting reforms to get back on track. The indication of tax cuts for the majority of those eligible has fuelled these fears.

Some Socially Just Redistribution

Those earning less than 40,000 euro will see their taxes reduced—this will benefit some 90% of taxpayers. Conversely, those earning over 75,000 euro will see taxes hiked to 43% from 41%. Previously this applied to those earning over 100,000 euro. The low tax morality of many means that this measure will affect just 1.6% of taxpayers, and is hardly likely to encourage increased morality from higher earners. In addition, the tax rate for those earning between 55,000 and 75,000 euro is to rise from 39% to 41%, which the opposition has said will unfairly hit the middle classes. Still, the government hopes for around 7 billion euro from the measures, and believes the budget to be socially corrective, in line with the principles of the European Union. In this vein, infrastructural projects are also planned for the comparatively underdeveloped south of the country. It is less clear how the government will proceed with its promises to fight tax evasion and increase morality, though it may be hoping for an increase in payments from the bulk of lower-income workers, with reduced rates encouraging taxpayers into the system. It has though included some measures on tax evasion, and also fines for those firms compromising health and safety regulations.

As part of a message to the electorate, the wages of government members will be cut by 30%, and spending in the Senate and regional authorities will also be cut back. The latter will lose 1.8% from their 2007 budgets. However, another controversial proposal will allow cities to impose a tourist tax of up to 5 euro per day. This would allow municipalities to plough money into maintenance of historical centres. The centre-right has threatened street protests, and accused Prodi of going back on campaign pledges not to raise taxes. However, the government has warned against taking to the streets.

Outlook and Implications

The economy continued to strengthen in the second quarter of 2006. Real GDP grew 0.5% quarter-on-quarter (q/q) after having risen 0.7% in the first quarter of the year. The economy was stronger than had been expected, which implies that real GDP growth could hit 1.5% in 2006, its strongest performance since 2001. Nevertheless, we still have major concerns about the underlying state of the Italian economy. Indeed, latest survey evidence is currently showing some signs of softening, although it is still healthy compared with recent norms. Consumer confidence is still well below its long-term average despite its recent overall improvement, while retail sales data remains largely muted. Furthermore, although business confidence has improved significantly in recent months, it still appears relatively fragile, having retreating in August before a surge in September. Coupled with the significant threats stemming from very high oil prices and a firmer euro, this indicator suggests that companies will be fairly cautious in the near term, at least over investment and employment. In addition, we believe that the euro will make further significant gains against the U.S. dollar in the latter stages of 2006 and in 2007.

Ratings agencies are holding off from making a decision on the proposals until they have been through parliament, where the government has only a narrow majority in the upper house. This will be a critical test of the strength of the government. In the lower house, where the government has a strong majority, approval should present no problem. In the upper house, the seven life senators may provide crucial support for the government, having backed it in the past when they felt that the measures were clearly for the benefit of the country, and particularly when the government had found a compromise between the diverging coalition interests. This is despite pressure from the opposition. According to the latest Ipsos poll, Italians remain divided on the government's performance thus far. Should the tax-cutting budget be approved, support could conceivably rise.

Contact

Raul Dary

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Tel: 781.301.9314
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Fax: 781.301.9416
raul.dary@globalinsight.com

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