Council opinion of 10 March 2009 on the updated stability programme of Italy, 2008-2011
Date: 2009-03-10
Institutions: Council of the European Union
Subjects: Italy, budget estimate, economic forecasting, public finance, stability programme

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I

(Resolutions, recommendations and opinions)

OPINIONS

COUNCIL

COUNCIL OPINION

of 10 March 2009

on the updated stability programme of Italy, 2008-2011

(2009/C 70/01)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveil-
lance of budgetary positions and the surveillance and coordination of economic policies (1), and in particular
Article 5(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

On 10 March 2009, the Council examined the updated stability programme of Italy, which covers the
period 2008 to 2011.

Adding to the long-standing structural weaknesses that have prevented satisfactory productivity
growth for several years, the global downturn is strongly impacting on the Italian economy, even
though the low indebtedness of the Italian private sector and a relatively solid financial system have
so far provided some shelter from the direct impact of the financial crisis. A marked slowdown of
real GDP growth in Italy was already under way in mid-2007, well before the deepening of the finan-
cial market crisis. It turned into recession in the second half of 2008, driven by faltering domestic
demand and declining exports. Restoring business and consumer confidence, ensuring access to
credit, in particular for SMEs, facilitating adjustment in the labour market to deal with rising unem-
ployment and improving the conditions for productivity growth and enhanced cost competitiveness
are key near-term challenges. In light of the very high government debt and the associated interest
burden, the Italian government's response to these challenges must be carefully balanced with the
need to avoid a substantial deterioration of public finances. The planned fiscal stance in 2009 is

(1) OJ L 209, 2.8.1997, p. 1. The documents referred to in this text can be found at the following website:

http://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

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broadly neutral. Within this context, the government adopted a recovery package in November 2008
in line with the European Economic Recovery Plan (EERP), aiming at supporting low-income house-
holds and firms, while accelerating public investment. Further measures were adopted in February
2009 to support demand for energy-efficient durable goods. Still, the economic downturn is weighing
heavily on the Italian public finances.

(3)

(4)

(5)

(6)

The macro-economic scenario underlying the programme envisages that, after falling by 0,6 % in
2008, real GDP will contract further in 2009, by 2 %. Real GDP growth is expected to recover
mildly, to 0,3 %, in 2010 and more decisively, to 1 %, in 2011. These macro-economic projections
take into account the recovery measures adopted on 28 November, the expected economic impact of
which is however not quantified. Assessed against currently available information (1), released after
the cut-off date for the programme projections, economic growth could be even lower than projected
in the programme. Also in the light of this, the 2009 projections for employment in the programme
seem to be rather optimistic, in particular as concerns hours worked. By contrast, the projections for
inflation appear realistic. The programme's inflation prospects and the underlying moderation in unit
labour cost growth in the medium term imply some containment of the competitiveness loss that
Italy has been experiencing since the late 1990s.

The Commission services'
January 2009 interim forecast estimates that the general government
deficit increased to 2,8 % of GDP in 2008, compared to the 2,2 % deficit target in the November
2007 update of the programme. The higher-than-expected outcome occurred in spite of a positive
base effect, as the 2007 deficit is now reported at 1,6 % of GDP as against 2,4 % expected in the
previous programme. The better 2007 starting position was more than offset by developments in
2008, partly related to the adverse economic conditions. In addition, higher interest rates entailed
increased debt servicing costs. A shortfall in revenue growth going over and above the impact of the
economic slowdown reflects the implementation of various discretionary measures, namely: the
take-up by employers in 2008 of the cut in the labour tax wedge (for workers on permanent
contracts) foreseen for 2007, the complete abolition of the tax on primary residential property and
the postponement to 2009 of some tax payment deadlines adopted with the economic recovery
package at the end of 2008. The structural deficit — that is, the cyclically-adjusted deficit net of
one-off and other temporary measures — is estimated to have increased by 0,5 percentage point of
GDP relative to 2007. This compares with a 0,25 percentage point improvement planned in the
November 2007 update of the programme.

According to the programme, the deficit is targeted to increase to 3,7 % of GDP in 2009, above the
3 % of GDP deficit reference value, from 2,6 % of GDP in 2008. This compares with a projection of
a deficit of 3,8 % in the Commission services' interim forecast. The widening of the deficit reflects
the operation of the automatic stabilisers, while the planned fiscal stance is broadly neutral. In par-
ticular, primary expenditure growth, albeit moderate by historical standards (3,1 % in nominal terms
compared to 4,5 % on average during the period 1999-2007), is assumed largely to outpace nominal
GDP growth. Revenue growth would slow down considerably, but by less than the tax base, also
reflecting a combination of one-off and permanent discretionary measures adopted with the recovery
and the three-year fiscal packages, as well as positive social contribution developments. Lower interest
rates would drive interest expenditure marginally down, despite a higher debt, thus providing some
limited relief to the public finances. As a result of these developments the structural balance recalcu-
lated by the Commission services on the basis of the information in the programme would improve
by 0,25 percentage point of GDP compared to 2008.

Regarding the medium-term budgetary strategy, the programme confirms the commitment to the
medium-term objective (MTO) of a balanced budgetary position in structural terms, but not the 2011
target date for its achievement. The economic downturn implies a delay in the budgetary consolida-
tion plan enshrined in the three-year fiscal package approved in summer 2008. The pledge to the
expenditure-based adjustment that was spelled out in that package is restated, in particular by broadly
confirming the medium-term projections for individual spending categories and the measures for its

(1) The assessment notably takes into account the Commission services' January 2009 forecast, but also other information

that has become available since then.

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achievement. However, although planned to be budgetary neutral, the implementation of the recovery
package implies some backloading of the expenditure-based adjustment, due to the acceleration of
investment and the one-off payments to households in 2009. After the sharp increase projected in
2009, the primary expenditure-to-GDP ratio would gradually return to a level similar to that esti-
mated for 2008 thanks to improved economic conditions and very subdued annual increases planned
over 2010-2011 (0,8 % on average in nominal terms). The revenue-to-GDP ratio is projected to
increase slightly between 2008 and 2011. After peaking in 2009, the headline deficit is planned to
decline to 3,3 % of GDP in 2010 and 2,9 % of GDP in 2011. A projected rebound in interest expen-
diture from 2010 implies that the primary balance is planned to improve at a faster pace. The recal-
culated structural balance would continue improving in 2010 and 2011, by a cumulative 1 percen-
tage point of GDP. The planned fiscal consolidation over 2010-2011 is driven by the constraints
stemming from the very high government debt. Having increased to just below 106 % of GDP in
2008, also reflecting the precautionary accumulation of liquid assets held with the Bank of Italy, the
government gross debt ratio is projected to continue increasing in 2009 and 2010, to a peak of
112 % of GDP, before slightly declining to 111,6 % in 2011. The main drivers of these developments
are the planned low primary surpluses and subdued nominal GDP growth. The stock-flow adjustment
projected in the programme is relatively small but it does not incorporate the possible implementa-
tion of the bank recapitalisation scheme adopted with the recovery package, as it has not yet been
utilised.

The deficit outcomes could be higher than projected in the programme throughout the covered
period. First, economic growth could be lower. Second, the subdued increase in primary expenditure
planned over 2010-2011 requires strict implementation, at all levels of government, of the expendi-
the
ture-based adjustment underlying the three-year package adopted in summer 2008. Third,
programme's projections for social contributions, notably for 2009, may not materialise, also given
the rather favourable underlying assumptions for employment growth. Finally, although planned to
be fully financed, the recovery package adopted in November 2008 and the new fiscal incentives for
the purchase of durable goods adopted in February 2009 (not incorporated into the programme)
might affect the 2009 budgetary outcome. For the same reasons, the evolution of the debt ratio from
2009 onwards might be less favourable than projected in the programme. The gross debt ratio could
also be affected by possible capital injections into the banking sector.

The long-term budgetary impact of ageing in Italy is lower than the EU average, with pension expen-
diture showing a more limited increase than on average in the EU, thanks to the adopted pension
reforms. Yet, pension expenditure as a share of GDP remains among the highest in the EU and the
projections hinge upon the assumption that the adopted reforms are fully implemented, in particular
that revised actuarial coefficients that are fully consistent with the contributory principle underlying
the reformed pension system are applied as of 2010. Additional measures could be considered,
notably a further increase in the retirement age, in particular for women. This would allow reallo-
cating social expenditure so as to move towards a more comprehensive and uniform unemployment
benefit system that ensures appropriate work incentives and effective activation policies. The
budgetary position in 2008 as estimated in the programme, which is worse than the starting position
of the previous programme, would be sufficient to stabilise the current debt ratio but would not
contribute to offsetting the projected long-term budgetary impact of ageing. Moreover, the current
level of gross debt is well above the Treaty reference value. Achieving and maintaining high primary
surpluses over the medium term would contribute to reducing the medium risks to the sustainability
of public finances.

Significant progress has been achieved in recent years to improve the fiscal framework, a key
pre-condition for a credible medium-term strategy of expenditure-based adjustment underpinned by
enhanced cost-effectiveness and efficiency of public expenditure. The three-year fiscal package
adopted in summer 2008 strengthens the medium-term fiscal framework by spelling out detailed
yearly caps for individual expenditure items and backing them up with broad measures. Several other
initiatives were introduced to improve budgetary institutions. The structure of the State budget was
rationalised by introducing a programme-based classification that allows a better allocation of
resources in line with government policy objectives. Enhanced flexibility is allowed to line ministries
to reallocate resources between spending programmes according to priorities. A pilot spending
review exercise was conducted in five ministries to assess cost-effectiveness of public expenditure and

(7)

(8)

(9)

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there is now the intention to make this an integral part of the budgetary process. Enforcement
mechanisms of the Domestic Stability Pact, governing fiscal relations between the different levels of
government, have been strengthened. Finally, important steps are being taken to improve the effi-
ciency and cost-effectiveness of the public administration, inter alia by promoting a more rational use
of available resources and better rewarding merit. Going forward, a major challenge for fiscal govern-
ance is to design a new framework for fiscal federalism that ensures the accountability of local
governments and fosters efficiency.

(10) At the end of 2008, in response to the global financial crisis, the Italian authorities adopted a series
of measures aimed at protecting savers and maintaining adequate levels of bank liquidity and capitali-
sation. These allow the government, until end 2009, to inject capital into banks in situations of
capital inadequacy and to guarantee new bank liabilities for up to five years. Moreover, a supplemen-
tary State guarantee for retail bank deposits was offered, further strengthening Italy's already relatively
high level of protection offered by the interbank deposit insurance scheme (that provides coverage for
just above EUR 100 000). Finally, with the aim to strengthen the system's overall ability to finance
economic activity, the Ministry of Economy and Finance has been allowed to underwrite financial
instruments issued by sound listed banks that would qualify as regulatory capital.

The public intervention, estimated in the programme at EUR 10 billion (around 0,7 % of GDP), is
intended to be temporary and banks availing of it must commit to lending to households and SMEs
on appropriate terms and conditions.

(11) Within a broadly neutral fiscal position, the government took measures to support the economy, in
line with the EERP, amounting to around 0,4 % of GDP in 2009 and 0,2 % in 2010. The budgetary
impact of these measures is, according to official estimates, fully offset by one-off revenues and some
permanent tax increases, mostly originating from fighting tax evasion and avoidance. Measures to
support disposable income of households and restore consumer confidence include a one-off cash
transfer to low-income households, extensions of unemployment benefits to atypical workers and
freezes on some utility tariffs. Support to companies is granted mainly in the form of the postpone-
ment of tax payment deadlines and a reduction of the corporate income tax burden. Tax relief on
performance-related pay tries to foster productivity while reducing labour costs. Finally, the govern-
ment is trying to re-allocate available EU or national funds so as to accelerate the implementation of
priority infrastructural projects. The measures are targeted and timely, provided that the planned
acceleration of public investment is achieved, and most of them are temporary in nature. Thus, their
reversibility is ensured, although not in full. The package is an adequate response to the economic
downturn in view of the very high debt ratio. In this context, and given the need to address the
productivity challenge and improve the external competitive position, structural reforms, including
strengthening the framework for competition, are particularly relevant
for Italy. A number of
announced structural measures, if already operational in 2009, may further support the recovery and
improve the resilience of the economy. These include initiatives to foster industrial
innovation,
promote the use of renewable energy sources and energy saving and reduce the administrative
burden. Recent steps by the social partners to modify the wage-bargaining framework, supported by
the above-mentioned fiscal incentives on performance-related pay, may lead to better alignment of
wage and productivity developments. These measures are related to the medium-term reform agenda
and the country-specific recommendations proposed by the Commission on 28 January 2009 under
the Lisbon Strategy for Growth and Jobs.

(12) After further increasing in 2009, the deficit is projected gradually to narrow over the programme
period. However, a reduction of the headline deficit below 3 % of GDP by 2011, as envisaged in the
programme, will require strong commitment to fiscal discipline and standing ready to adopt addi-
tional measures if necessary. The debt ratio will be increasing over the programme period, moving
further away from the reference value.

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(13) As regards the data requirements specified in the code of conduct for stability and convergence

programmes, the programme provides all required and most of the optional data (1).

The overall conclusion is that fiscal policy and the economic recovery package for 2009 are in line with the
European Economic Recovery Plan (EERP) and can be regarded as adequate in view of the very high debt
ratio. Reflecting the strong economic downturn associated with the financial crisis, the headline deficit is
expected to increase significantly in 2009 to above the 3 % of GDP reference value. In 2010 and 2011, the
programme foresees an expenditure-based adjustment, which would bring the deficit just below 3 % of GDP
in 2011. However, the achievement of the deficit targets throughout the programme period might be
hampered as economic growth could be even lower than planned. In addition, possible slippages in the
implementation of the planned restraint in primary expenditure may materialise, even though the improved
fiscal framework enhances the conditions for fiscal discipline and spending efficiency. The debt ratio is set to
increase from 104,1 % of GDP in 2007 to over 111 % of GDP by the end of programme period. The gross
debt ratio might increase further also as a result of possible capital
injections into the banking sector.
Finally, important structural weaknesses still hamper sustained productivity growth in Italy and weigh on its
external competitive position, while the current composition of social spending is not supportive of adjust-
ment in the labour market.

In view of the above assessment, Italy is invited to:

(i) implement the planned fiscal policy for 2009 and carry out with determination the adjustment path
planned over the programme period in order to set the very high debt ratio on a steadily declining path
and ensure the long-term sustainability of public finances;

(ii) continue the progress made to improve fiscal governance and the work on a new framework for fiscal

federalism that ensures the accountability of local governments and underpins fiscal discipline;

(iii) pursue efforts to improve the quality of public finances by focussing on spending efficiency and compo-
sition, also by reallocating social expenditure so as to create room for a more comprehensive and
uniform unemployment benefit system that ensures appropriate work incentives and effective activation
policies, without compromising the fiscal consolidation process.

Comparison of key macro-economic and budgetary projections

Real GDP
(% change)

SP Feb 2009

1,5

– 0,6

– 2,0

0,3

1,0

2007

2008

2009

2010

2011

COM Jan 2009

1,5

– 0,6

– 2,0

0,3

n.a.

SP Nov 2007

1,9

1,5

1,6

1,7

1,8

HICP inflation
(%)

SP Feb 2009

2,0

3,5

1,2

1,7

2,0

COM Jan 2009

2,0

3,5

1,2

2,2

n.a.

SP Nov 2007

1,9

2,0

2,0

1,8

1,9

(1) Gaps in the optional data include expenditure by function and some details on the breakdown of general government debt

developments.

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Output gap (1)
(% of potential GDP)

SP Feb 2009

COM Jan 2009 (2)

2007

2008

2009

2010

2011

1,7

1,8

0,3

0,3

– 2,3

– 2,7

– 2,5

– 2,3

– 2,7

n.a.

Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

General government
revenue
(% of GDP)

General government
expenditure
(% of GDP)

General government
balance
(% of GDP)

SP Nov 2007

– 0,6

– 0,6

– 0,6

– 0,6

– 0,6

SP Feb 2009

– 1,6

– 1,6

– 1,3

– 1,1

– 0,9

COM Jan 2009

– 1,6

– 2,2

– 1,3

– 1,5

n.a.

SP Nov 2007

– 1,3

– 0,8

– 0,6

– 0,4

– 0,2

SP Feb 2009

46,6

46,4

46,8

46,8

46,6

COM Jan 2009

46,6

46,4

46,5

46,5

n.a.

SP Nov 2007

46,2

46,3

45,9

45,8

45,7

SP Feb 2009

48,2

49,0

50,5

50,0

49,5

COM Jan 2009

48,2

49,2

50,3

50,2

n.a.

SP Nov 2007

48,6

48,5

47,9

47,3

47,0

SP Feb 2009

– 1,6

– 2,6

– 3,7

– 3,3

– 2,9

COM Jan 2009

– 1,6

– 2,8

– 3,8

– 3,7

n.a.

SP Nov 2007

– 2,4

– 2,2

– 1,5

– 0,7

Primary balance
(% of GDP)

SP Feb 2009

COM Jan 2009

SP Nov 2007

3,4

3,4

2,5

2,5

2,3

2,6

1,3

1,0

3,4

1,9

1,2

4,2

0,0

2,6

n.a.

4,9

Cyclically-adjusted
balance (1)
(% of GDP)

SP Feb 2009

– 2,4

– 2,7

– 2,6

– 1,9

– 1,6

COM Jan 2009

– 2,5

– 2,9

– 2,7

– 2,4

SP Nov 2007

– 2,0

– 1,9

– 1,2

– 0,4

n.a.

0,2

Structural balance (3)
(% of GDP)

SP Feb 2009

– 2,5

– 2,9

– 2,7

– 2,0

– 1,7

COM Jan 2009

– 2,6

– 3,1

– 2,8

– 2,5

SP Nov 2007

– 2,2

– 2,0

– 1,3

– 0,5

n.a.

0,2

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Government gross debt
(% of GDP)

SP Feb 2009

COM Jan 2009

SP Nov 2007

2007

2008

2009

2010

2011

104,1

104,1

105,0

105,9

105,7

103,5

110,5

109,3

101,5

112,0

110,3

98,5

111,6

n.a.

95,1

Notes:
(1) Output gaps and cyclically-adjusted balances according to the programmes as recalculated by Commission services on the basis of the

information in the programmes.

(2) Based on estimated potential growth of 1,1 %, 0,9 %, 0,6 % and 0,7 % respectively in the period 2007-2010.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. One-off and other temporary measures are 0,1 % of GDP
in 2007, 0,2 % in 2008 and 0,1 % 2009-2011; all deficit-reducing according to the most recent programme and in the Commission
services' January interim forecast.

Source:
Stability programme (SP); Commission services' January 2009 interim forecasts (COM); Commission services' calculations.