A structural analysis of Italy's fiscal policies after joining the european monetary union: are we learning from our past?

Author:Marino, Maria Rosaria
Position:Report
 
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  1. INTRODUCTION

    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. With the reform of the Stability and Growth Pact in 2005, the structural balance (i.e. ad justed for cyclical effects and temporary measures) has become the main indicator for multilateral surveillance of fiscal policies. In particular, the reformed Pact requires countries not in an excessive deficit situation but with budgetary imbalances to aim for an annual improvement in the structural balance of 0.5 per cent of GDP as a benchmark, while undertaking greater consolidation efforts during favourable periods. The exclusion of temporary measures is designed to ensure that actions taken to comply with European fiscal rules lead to a permanent improvement in the public accounts (evidence of many countries using temporary measures to comply formally with the European rules can be found in Koen and van den Noord, 2005 and Buti et al., 2006). Identifying temporary measures and assessing their effects is not always straightforward. In the paper we use the criteria adopted by the Bank of Italy, which are generally in line with the guidelines set by the European Commission (European Commission, 2006).

    Many of the issues examined in this study have also been discussed, in relation to other periods, in previous works on Italian budgetary policy (e.g. Bosi et al., 1990; Bernasconi and Marenzi, 1998; Sartor, 1998; Spaventa and Chiorazzo, 2000; Crescenzi, 2007). Some periods after 1997 have been examined, inter alia, by Degni et al. (2001), Balassone et al. (2002), Franco (2005) and Franco and Rizza (2008). Analyses of individual years and specific sector aspects can be found in the Report published annually by the Bank of Italy and in the yearly reports on Italian public finances published by Il Mulino.

    Our study has also some bearing on the recent strand of literature that studies the factors behind the success of fiscal consolidations, measured according to fiscal performance in subsequent years (for an updated survey and empirical analysis, see European Commission, 2007a). In line with some of the findings of this literature, we show that the deterioration in the public finances in 1998-2003 is connected with the heavy reliance on tax increases and capital spending cuts in the fiscal consolidation of the years 1992-97.

    Sections 2 and 3 discuss the criteria used to assess cyclical effects and identify temporary measures, comparing them with those used by other international institutions. Section 4 describes the methodology used to evaluate the structural evolution of the main budgetary items. Section 5 presents the main results of the analysis. Section 6 concludes.

  2. THE EFFECTS OF THE ECONOMIC CYCLE

    In the majority of cases, the estimates of the cyclically-adjusted balances are obtained by a two-step procedure (for a survey, see Banca d'Italia, 1999). The first step identifies the cyclical gap of one or more macroeconomic variables with respect to their "normal" trend, while the second computes the cyclical effect on each budgetary item as the product of three factors: the cyclical gap of the most directly relevant macroeconomic variable, the budgetary item in level, and the latter's elasticity to the economic variable. In the methodologies adopted by the European Commission (Denis et al., 2002)., the IMF (Hagemann, 1999) and the OECD (Richardson et al., 2000; Girouard and Andre, 2005), the measure of the cycle to correct for is identified by the output gap, i.e. the difference between actual GDP and potential output estimated by a Cobb-Douglas production function with exogenous trend. Some of the potential levels of the inputs are estimated with a univariate HP filter, while others are derived from structural analysis (Cotis et al., 2003). The elasticity of each budgetary item to the output gap is given by the product of the elasticity of the budgetary component to a relevant macroeconomic variable (usually derived from tax and expenditure rules) and the elasticity of the latter with respect to output (usually estimated econometrically). For the period 1981-2006, Figure 1 charts the growth rates of potential output according to the estimates of the European Commission, the OECD and the IMF and compares them with the actual growth rate of real GDP. The histograms show the output gap as estimated by the European Commission.

    [FIGURE 1 OMITTED]

    The method used in this paper (Banca d'Italia, 1998b; Momigliano and Staderini, 1999; Bouthevillain et al. , 2001) differs from the ones described above. In fact, the cyclical position of the economy is not summarized by the output gap; it is identified with reference to a set of macroeconomic variables. These variables have been chosen because they have sizeable effects on the main revenue and expenditure items of the government budget (namely consumption on indirect taxes, employment and unit wages in the private sector on households' income tax and social security contributions, gross operating surplus on corporate income tax and unemployment rate on unemployment expenditure).

    In the first step of the procedure, the cyclical component of each macroeconomic variable is estimated applying to the series in real terms an HP filter (Hodrick and Prescott, 1997), with the X parameter set equal to 30 (on this choice, see Bouthevillain et al., 2001). The OECD, which uses broadly the same variables, computes the cyclical component of each as the product of the output gap and a constant elasticity (Figure 2). In the second step, which does not differ from that of the OECD, we compute the cyclical component of the main budgetary items as the product of the cyclical gap of the economic variable and the elasticity of the revenue or expenditure item to its reference variable. The method is basically the same as the one presented in Bouthevillain et al. (2001). The main departure consists in using the GDP deflator (as opposed to the consumption price deflator) to compute real unit wages. The GDP deflator is also used for the gross operating surplus (as in Bouthevillain et al., 2001). Real consumption is computed using the consumption price deflator.

    [FIGURE 2 OMITTED]

    Compared with the methods based on the output gap, the methodology used in this paper can capture better the effects on the budget of non-systematic changes in the composition of both aggregate demand and na tional income. These composition effects arise because tax imposition is not distributed uniformly across all the components of aggregate demand and income. Estimates of the cyclical components based on the output gap only embody average changes in the tax bases when GDP changes. However, these methodologies usually adopt a more structural approach in order to estimate the potential output and, in this respect, they exploit a larger information set than a univariate filter.

    In general, the two approaches lead to similar results, as they agree on some critical aspects such as the values of the elasticities and the average length of the business cycle. In Figure 3 our...

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