A Structural Analysis of Italy's Fiscal Policies after Joining the European Monetary Union: Are We Learning from Our Past?

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Italy's public finances improved dramatically in the period 1992-97, helping to secure participation in the European Monetary Union from the outset. There was considerable fiscal loosening in the years that followed, and the primary balance declined steadily from almost 7 per cent of GDP in 1997 to virtually zero in 2006. The paper examines the development of public finances from 1998 to 2006. The "structural" developments in the main budgetary components are assessed, excluding the effects of the economic cycle and of temporary measures. The analysis shows a rapid deterioration up to 2003, whose roots can be traced back to the consolidation of the early 1990s, achieved primarily by means of tax increases and cuts in capital expenditure. Since 2004 there has been a structural improvement, initially modest but substantial in 2006. Sustaining this adjustment and making further progress may again prove difficult, as the fiscal correction is similar in nature to the previous consolidation effort.

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After 1997, the year of qualification for participation in the European Monetary Union, Italy's public finances entered a phase of rapid and continuous deterioration. The primary balance, which had stood at 6.6 per cent of GDP in 1997, was virtually nil in 2006.1 The extent of this deterioration was not immediately clear in the public debate. In the early years, the worsening of the primary balance was largely offset by the reduction in interest payments. Moreover, initial estimates of the yearly balance (published in the spring of the following year) were systematically more favourable than later assessments. Only in 2005 did the European Council identify the presence of an excessive deficit and ask the Italian government to redress the situation by 2007 at the latest.

This paper aims to identify some of the causes of the deterioration in the public accounts over the period 1998-2006. We distinguish between medium-term trends, fiscal actions with permanent effects, and temporary factors. The focus of our analysis is on the budget balance but clearly its worsening slowed down the reduction of the debt-to-GDP ratio. In the period 1997-2006, the debt declined from 118.1 to 106.8 per cent of GDP, in the context of government plans targeting the ratio (at least until 2003) to fall by more than 3 percentage points per year on average. Moreover, approximately 8 points of the achieved reduction are due to some extraordinary operations concerning debt restructuring and the sale of assets (Momigliano and Rizza, 2007).

Our analysis is largely based on a methodology developed in the European System of Central Banks (See Kremer et al., 2006a, and, for applications of the method in specific countries, Kremer and Wendorff, 2004; Braz, 2006; Kremer et al., 2006b; and National Bank of Belgium, 2006). The first step is to identify the structural levels of the main budget categories by excluding the effects of the economic cycle and of temporary government measures. These effects are usually the most important transitory factors, but we are still far from capturing the influence of all temporary factors on public finances. Other temporary factors with an impact on revenue include fluctuations in interest rates and in prices of real estate, stocks and oil. Taking into account these and other transitory influences in a standardized procedure would have required introducing a number of ad hoc assumptions. In the second step, the impact of a few important elements on the development of structural revenue is examined.

There is a long tradition of cyclical adjustment in the analysis of public finances, dating back at least half a century (e.g. Brown, 1956). Here we assess these effects with a methodology used in the Bank of Italy; the results are compared with the estimates made available by the European Commission, the IMF and the OECD.

In Europe it has only recently become commonplace to take the effects of temporary measures into account as well. …