COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Italy 2014
Date: 2014-03-05
Institutions: European Commission
Subjects: Euro Group (euro area), Italy, budget deficit, competitiveness, economic growth, macroeconomics, productivity, public debt, stability pact, trade balance













EUR-Lex - 52014SC0083 - EN











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52014SC0083

COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Italy 2014 /* SWD/2014/083 final */









Results of in-depth reviews under
Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic
imbalances
Italy is experiencing excessive macroeconomic imbalances, which require
specific monitoring and strong policy action. In particular, the
implications of the very high level of public debt and weak external
competitiveness, both ultimately rooted in the protracted sluggish productivity
growth, deserve urgent policy attention. The need for decisive action so as to
reduce the risk of adverse effects on the functioning of the Italian economy
and of the euro area, is particularly important given the size of the Italian
economy. The Commission intends to put in motion a specific monitoring of the
policies recommended by the Council to Italy in the context of the European
Semester, and will regularly report to the Council and the Euro Group.
More specifically,
high public debt puts a heavy burden on the economy, in particular in the
context of chronically weak growth and subdued inflation. Reaching and
sustaining very high primary surpluses – above historical averages – and robust
GDP growth for an extended period, both necessary to put the debt-to-GDP ratio
on a firmly declining path, will be a major challenge. In 2013, Italy has made
progress toward its medium-term fiscal objective. However, there is a risk that
the adjustment of the structural balance in 2014 is insufficient given the need
to reduce the very large public debt ratio at an adequate pace. The crisis has
eroded the initial resilience of the Italian banking sector and weakens its
role to support the recovery of the economy The losses of competitiveness are
rooted in a continued misalignment between wages and productivity, a high
labour tax wedge, an unfavourable export product structure and a high share of
small firms which find it difficult to compete internationally. Rigidities in
wage setting hinder sufficient wage differentiation in line with productivity
developments and local labour market conditions. Long-standing inefficiencies
in the public administration and judicial system, weak corporate governance,
and high levels of corruption and tax evasion reduce the allocative efficiency
in the economy and hamper the materialisation of the benefits of the adopted
reforms. Large human capital gaps – reflecting low returns to education for
younger generations, the country's specialisation in low-to-medium technology
sectors and structural weaknesses in the education system – adds to the
productivity challenge. 
Excerpt of country-specific findings on Italy, COM(2014) 150 final,
5.3.2014
Executive Summary and Conclusions 7
1.       Introduction  11
2.       Macroeconomic
Developments 13
3.       Imbalances
and Risks 21
3.1.     High public
indebtedness 21
3.2.     Loss of
external competitiveness 24
3.2.1.  Export
performance  25
3.2.2.  Developments
in current and financial accounts and net external position  26
3.2.3.  Cost/price
competitiveness 30
3.3.     Italy's
productivity challenge  35
3.3.1.  Capital
allocation and innovation  37
3.3.2.  Human capital
accumulation  39
3.3.3.  Underlying
weaknesses in governance and public administration  42
3.4.     Euro-area
spillovers 44
3.4.1.  Trade and
financial linkages between Italy and the rest of the euro area   44
3.4.2.  Italy's
imbalances and spillovers to the euro area   45
3.4.3.  Macroeconomic
developments in the euro area and adjustment in Italy  46
4.       Policy
Challenges 49
References 51
LIST OF Tables
2.1.     Key
economic, financial and social indicators - Italy  20
LIST OF Graphs
2.1.     Evolution
of total factor productivity (1999 = 100) 13
2.3.     12-month %
change in MFI loans to Italian firms 14
2.4.     Evolution
of employment (2007 = 100) 15
2.5.     Employment
by Italian region (Q4 1999 = 100) 15
3.1.     Decomposition
of the changes in Italy's public debt-to-GDP ratio  21
3.2.     Annual
average % change in export volumes of goods and services, 25
3.3.     Evolution
of world export market shares in goods and services (value terms) (1999 = 100) 25
3.4.     Geographical
breakdown of Italy's export performance in volumes (07Q1 = 100) 26
3.5.     Italian
exports by technological intensity  26
3.6.     Evolution
and decomposition of Italy's current and capital accounts 26
3.7.     Italy's
saving (by sector) and investment 27
3.8.     Decomposition
of Italy's good balance correction over the period 2011-13  27
3.10.   Financial
account of Italy's balance of payments – Italian liabilities (simplified) 28
3.9.     Financial
account of Italy's balance of payments – Italian assets (simplified) 29
3.11.   Decomposition
if Italy's net international investment position  29
3.12.   Main foreign
capital outflows driving the build-up of Italy's TARGET 2 liabilities 30
3.13.   Evolution of
labour productivity (1999 = 100) 30
3.14.   Evolution of
the REER based on nominal ULC (1999 = 100) 30
3.15.   Evolution of
the REER based on producer prices in manufacturing (Jan 1999 = 100) 31
3.16.   Nominal
hourly compensation of employees (07Q1 = 100) 31
3.17.   Decomposition
of unit labour costs for exporting and manufacturing firms before and during
crisis 31
3.18.   Phillips
curve - Growth rate of hourly compensation of employees in Italy  32
3.19.   Phillips
curve - Growth rate of hourly negotiated wages in Italy  32
3.20.   Real
compensation of employees in industry excluding construction (99Q1 = 100) 33
3.21.   Foreign
value-added content of exports 34
3.22.   Growth
accounting 1999-2012  36
3.23.   Growth
accounting - Difference between euro period (1999-2012) and pre-euro period
(1992-1999) 36
3.24.   Value added
per person employed in the manufacturing sector (by firm size) (EU27 = 100) 36
3.25.   Distribution
of manufacturing workers over firm size classes 36
3.26.   Gross fixed
capital formation (excluding dwellings) 37
3.27.   Countries
ordered by marginal efficiency of capital 37
3.28.   Birth and
death rates of Italian firms 38
3.29.   Share of ICT
investment in total non-residential gross fixed capital formation  38
3.30.   Venture
capital investments in selected EU countries 39
3.31.   Share of
population aged 25-34 with less than upper secondary education (ISCED levels
0-2) 39
3.32.   Share of
population aged 25-34 with tertiary education (ISCED levels 5-6) 41
3.33.   Age-earnings
profiles in major European countries, 2010 (<30 yrs = 100) 41
3.34.   Share of
population aged 15-29 by education and employment status, 2012  42
3.35.   Share of
population aged 30-34 with tertiary education, by type of programme (2011) 42
3.37.   Geographical
distribution of Italian banks' foreign liabilities to foreign euro-area banks,
Q3 2013  44
3.36.   Decrease in
exports of euro-area countries as a result of 10% decrease in Italian domestic
demand   45
3.38.   Effect of
reforms in Italy on euro-area GDP  46
3.39.   Spillovers of
structural reforms in Italy on other euro-area members 46
3.40.   Variance in
sovereign spreads explained by a common factor 46
3.41.   First-year
impact of a 5% real appreciation on Italy's exports 47
3.42.   Impact of a
5% real appreciation on Italy's GDP  47
LIST OF Boxes
2.1.     Developments
in the Italian banking sector 17
3.1.     Simulations
of Italian public debt sustainability  23
3.2.     The labour
market reform and collective bargaining framework  35
LIST OF Maps
No table of contents
entries found.
In April 2013, the Commission concluded
that Italy was experiencing macroeconomic imbalances, in particular as regards
developments related to its export performance and underlying loss of
competitiveness as well as high general government sector indebtedness. In the
Alert Mechanism Report (AMR) published on 13 November 2013, the Commission
found it useful, also taking into account the identification of imbalances in
April, to examine further the risks involved in the persistence of imbalances.
To this end, this In-Depth Review (IDR) provides an economic analysis of the
Italian economy in line with the scope of the surveillance under the
Macroeconomic Imbalance Procedure (MIP). The main observations and findings
from this analysis are:
·       Persistently dismal growth exacerbates the Italy's macroeconomic
imbalances and reform efforts so far appear to be insufficient. Over the last fifteen years, economic growth in Italy has been
weaker than in the rest of the euro area, primarily because of sluggish
productivity growth. The crisis has aggravated the country's structural
weaknesses, while growth prospects remain unfavourable and social and regional
divides are increasing. Reform efforts so far appear to be insufficient to re‑launch
productivity growth, also due to inadequate implementation and, at times,
inconsistent policy strategies. Italy's poor productivity performance is at the
root of the country's declining external competitiveness and weighs on the
sustainability of its high public debt.
·       The very high government debt remains a heavy burden for the Italian
economy and a major source of vulnerability, especially in a context of
protracted weak growth. Under strong
financial-market pressure, Italy undertook a significant fiscal adjustment effort
between 2011 and 2013 that averted immediate sustainability risks. In addition,
past pension reforms – once fully implemented – will have a beneficial effect
on the medium-to-long-term sustainability of Italy's public finances. However,
stylised simulations up to 2020 show that high primary surpluses and sustained
nominal growth are both necessary to put the debt ratio on a satisfactory
declining path. Meeting these conditions requires continued fiscal discipline
and decisive structural reforms to boost productivity and competitiveness.
·       The correction of Italy's current account balance is mostly driven
by falling imports while export competitiveness has not improved. In 2013, the Italian current account balance returned to surplus.
Its sharp correction since mid-2011 is mainly due to falling domestic demand.
While the risk of an immediate return to pre-crisis current account deficits is
limited, Italy’s export competitiveness remains weak, as reflected by the
continued erosion of its export market shares, in particular vis-à-vis
euro-area trade partners.
·       Wage dynamics not aligned with productivity developments weigh on
cost competitiveness, while non-cost factors remain unfavourable. Italy's unit labour costs have been rising relative to trade
partners since the beginning of the 2000s. There are signs that nominal wages
are adjusting, mainly because of a freeze in public sector wages. However,
collective bargaining remains highly centralised at the sectoral level and
largely unresponsive to firm-level productivity and local labour market
conditions. Furthermore, a high tax wedge weighs on the cost of labour. Cost
pressures also stem from the country's heavy reliance on imported energy and
the high cost of doing business. Finally, Italy's competitiveness is hampered
by an unfavourable product specialisation and a high share of small firms with
a weak competitive position in international markets.
·       Long-standing structural weaknesses distort the allocation of labour
and capital, hold back innovation and technology absorption and hamper the
beneficial impact of reforms already taken. Despite
progress in improving labour and product markets regulation, remaining barriers
to competition, inefficiencies in the public administration and judicial system
and governance weaknesses hinder the reallocation of resources towards
productive firms and sectors. The insufficient development of capital markets
holds back technology absorption and innovation further. These factors also
limit the inflow of foreign direct investment into Italy and hamper the impact
of reforms on the ground. 
·       Italy’s human capital accumulation is failing to adapt to the needs
of a modern competitive economy. Italy has the
fourth highest share of population with only basic education and the lowest
share with tertiary education in the EU. Labour market segmentation, a
difficult transition from education to work as well as a wage structure which
favours old incumbents signal that the burden of slow growth and adjustment
largely falls on the younger cohorts and result in low returns to education
compared to the rest of the EU. Structural weaknesses in the education system,
including high drop-out rates during early years of both the secondary and
tertiary level, as well as low participation in life-long learning programmes,
further contribute to Italy's skill gap. The economy's high share of low-to-medium
technology sectors is both a further driver and an outcome of these
developments.
·       The crisis has eroded the initial resilience of the Italian banking
sector and has weakened its capacity to support the economic recovery. The protracted recession is taking its toll on Italian banks'
balance sheets through a strong increase in non-performing corporate loans,
which weigh on profitability. Credit supply conditions, especially for (small)
firms, remain tight. The increased exposure to the domestic sovereign has made
banks more vulnerable to public finance developments. Despite a gradually
improving liquidity situation, Italian banks remain to a large extent dependent
on Eurosystem funding. Overall, the sector has strengthened its capital
position in recent years, but second-tier medium-sized institutions appear
weaker than the rest of the sector.
·       Italy’s macroeconomic imbalances have negative spillover effects on
the euro area as a whole. Italy's GDP accounts for
around 16.5% of euro-area GDP. Its slow growth acts as a drag on the recovery
of the euro area as a whole. Furthermore, the country's high debt could impact
the euro area by affecting financial market sentiment and confidence. At the
same time – within the context of the monetary union – low demand and low
inflation in the rest of the euro area make Italy's adjustment more difficult.
The IDR also discusses the policy
challenges stemming from these imbalances and possible avenues for the way
forward. A number of elements can be considered:
·       Italy has for too long postponed much-needed structural reforms. The lack of reform in the past and the size of the policy
challenges facing the Italian economy have made it all the more urgent to fully
and effectively implement the measures already adopted and decisively step up
the pace of reforms, while ensuring a fair distribution of the burden of
adjustment. The decline in financial-market pressures in recent months and the
gradual improvement of the economic outlook represent a precious window of
opportunity in this respect.
·       Robust productivity-enhancing reforms would help to ensure a
sustainable recovery and unleash Italy's growth potential. Policy actions could include: addressing long-standing
inefficiencies in the public administration and judicial system, fostering the
modernisation of corporate governance practices in the public and private
sector, fighting corruption and the shadow economy, and removing the remaining
barriers to competition in product markets. Addressing hindrances to human
capital accumulation, both in the education system and in the labour market,
would significantly enhance Italy's growth prospects. Reigniting the flow of
credit to the real economy and further developing capital markets would ensure
adequate financing to innovative activities. Finally, enabling existing pockets
of export strength to increase their weight in the overall economy and
fostering the creation and growth of innovative firms, in particular by
removing impediments to the reallocation of resources to more productive
tradable sectors, would help to create the conditions for dynamic and
sustainable growth. 
·       Reducing the high government debt at a satisfactory pace requires
sustained fiscal discipline. Reaching the
medium-term objective (MTO) of a structurally balanced budget and achieving and
maintaining sizeable primary surpluses for an extended period of time are
essential to put Italy's high government debt-to-GDP ratio on a steadily
declining path, while preserving investor confidence. Sustained fiscal
discipline needs to be supported by growth-enhancing strategies.
·       As productivity-enhancing measures take time to bear fruit, levers
to address cost pressures in the economy could be explored. Maintaining labour cost moderation and overcoming rigidities in
wage-setting to allow wage differentiation would help Italy to regain cost
competitiveness in the short run. Wage differentiation, which accounts for the
large disparities in productivity and labour market conditions in the economy,
would also help to improve the economy's allocative efficiency and enhance
productivity. Possible deflationary risks with negative consequences for
private and public debt dynamics would warrant close monitoring. Decisive
measures to shift the tax burden away from productive factors in a
budget-neutral way would also help to support external competitiveness and make
the tax system more growth-friendly. In addition, immediate action could start
to address the high cost of doing business, in particular by simplifying tax
compliance and administrative procedures.
On 13 November 2013, the European
Commission presented its third Alert Mechanism Report (AMR), prepared in
accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention
and correction of macroeconomic imbalances. The AMR serves as an initial
screening device helping to identify Member States that warrant further
in-depth analysis to determine whether imbalances exist or risk emerging.
According to Article 5 of Regulation No. 1176/2011, these country-specific
“in-depth reviews” (IDR) should examine the nature, origin and severity of
macroeconomic developments in the Member State concerned, which constitute, or
could lead to, imbalances. On the basis of this analysis, the Commission will
establish whether it considers that an imbalance exists in the sense of the
legislation and what type of follow-up it will recommend to the Council.
This is the third IDR for Italy. The
previous IDR was published on 10 April 2013 on the basis of which the
Commission concluded that Italy was experiencing macroeconomic imbalances, in
particular as regards developments related to its export performance and underlying
loss of competitiveness as well as high general government indebtedness.
Overall, in the AMR the Commission found it useful, also taking into account
the identification of imbalances in April, to examine further the risks
involved in the persistence of imbalances. To this end this IDR provides an
economic analysis of the Italian economy in line with the scope of the
surveillance under the Macroeconomic Imbalance Procedure (MIP).
Growth performance and inflation outlook
Italy's growth performance has been
persistently weak in comparison to its euro‑area partners. Between 1999 and 2007, Italy's annual real GDP growth averaged
1.6%, significantly lower than the euro‑area average of 2.2%. The main
reason for Italy's weak growth performance was stagnant total factor
productivity (TFP) (Graph 2.1), while investment increased at a
similar pace as in the rest of the euro area (see also Section 3.3).
The crisis exacerbated Italy's growth gap. Italy's output loss during the crisis – driven by a strong decline
in investment – has exceeded that of most of its euro‑area peers (Graph 2.2). Between 2007 and 2013, Italy's real
GDP contracted by 8.7% compared to a fall of 1.7% for the euro area as a whole.
After the sharp contraction in 2008-09, the economy rebounded in 2010, but
entered a second recession in the second half of 2011. Real GDP contracted by
2.5% in 2012 and a further fall of 1.9% was recorded in 2013, based on
quarterly data.
Growth prospects remain unfavourable in
the short term. The Commission 2014 Winter
Forecast ([1])
("Commission Forecast" hereafter) projects a slow recovery, lifting
real GDP by 0.6% in 2014. Economic activity is expected to be primarily
supported by exports which will in turn foster investment. In 2015, growth is
expected to accelerate to 1.2% as financing conditions are projected to ease
and external demand continues to support exports. However, potential growth is
estimated to be flat over 2014‑15, with labour and capital accumulation
as well as TFP providing no contribution. 
The crisis triggered a sharp reversal of
private foreign capital flows into Italy and a related strong current account
adjustment. In the second half of 2011, private
capital flows from abroad dried up given widespread risk aversion vis-à-vis
Italy and other vulnerable euro-area countries following the sovereign debt
crisis. This was associated with a sharp correction of the current account
balance which turned positive in the course of 2013. The Commission Forecast
projects the current account balance to stabilise at a surplus slightly above
1% of GDP in 2014-15. 
Inflation is set to remain very moderate
over the forecast horizon. Limited labour cost
pressures combined with weak consumption and stable energy prices lead the
Commission Forecast for HICP-based inflation to fall to 0.9% in 2014, and then
increase to 1.3% in 2015 as the economic recovery strengthens.
Public finance developments
The medium‑term objective (MTO) of
a balanced budgetary position in structural terms has not been achieved yet. Rapidly rising sovereign bond yields forced the Italian authorities
to undertake a fast fiscal consolidation, which enabled Italy to reduce its
headline public deficit from 5.5% of GDP in 2009 to 3% in 2012 and exit the
excessive deficit procedure (EDP) in June 2013. In the same period, the
structural primary balance improved even more, i.e. by more than 3.5 pps. of
GDP. The fiscal adjustment affected both the expenditure and the revenue sides.
On the expenditure side, public wages have been frozen since 2011 and new
recruitment has been significantly reduced, while indexation of higher pensions
to inflation has been frozen and the retirement age has been raised. On the
revenue side, the standard VAT rate was raised in two steps from 20% to 22%. In
addition, taxation of households' financial wealth and especially immovable
property has been increased. After stabilising at 3% of GDP in 2013, the
Commission Forecast projects the government deficit to fall to 2.6% in 2014 and
2.2% in 2015, in the absence of policy changes. The structural balance is
estimated to have further improved in 2013 (to -0.8% of GDP from -1.4% in
2012). A marginal improvement (to -0.6% of GDP) is also expected in 2014, while
the structural balance is set to worsen in 2015 under a no-policy-change
assumption. The structural primary surplus is expected to remain stable at
around 4.5% of GDP over 2013-15. 
Italy's general government debt‑to‑GDP
ratio has increased. In spite of fiscal
consolidation, Italy's public debt-to-GDP ratio rose from 103.3% in 2007 to
just below 133% in 2013, driven by a combination of negative real growth and
continued fiscal deficits, as well as financial support to euro‑area
programme countries and the settlement of government trade debt arrears (for an
amount of around 3.6% and 1.4% of GDP respectively). After incorporating the
effects of the further settlement of trade debt arrears (1.6% of GDP) and
privatisation proceeds (0.5% of GDP), the general government debt ratio is set
to peak in 2014 (at 133.7% of GDP) and then decline slightly in 2015 thanks to
the projected higher primary surplus and nominal GDP growth.
Financing conditions
Italian firms have been negatively
affected by the protracted economic downturn and high corporate bank lending
rates hamper economic recovery. The double-dip
recession and the increased lending rates following sovereign risk premium
developments have put pressure on Italian firms' profitability. Although
Italian non‑financial firms' indebtedness as a share of GDP is below the
euro-area average, their leverage is rather high, especially due to a debt bias
in their funding. At the end of 2013, the average interest rate on a new
corporate loan was respectively 128 and 110 basis points higher than in Germany
and France. Small firms in Italy faced a lending rate which on average was 207
basis points higher than for large Italian firms. Tight supply conditions,
combined with subdued loan demand, have led to a strong contraction of credit
to firms (Graph 2.3). Box 2.1 discusses the general state of the
Italian banking sector and its role within the economy more widely.
Employment and social conditions
The long and deep recession has dampened
employment prospects. Employment in Italy did not
fall as much as in other vulnerable euro-area countries (Graph 2.4), but the already wide regional
disparities increased further, with the South of the country absorbing most of
the decline (Graph 2.5). Italy's unemployment rate doubled from
6.1% in 2007 to 12.2% in 2013, while remaining lower than in Spain and
Portugal. At the same time, there has been a sharp reduction in the number of
hours worked per employee, largely owing to the massive use of the wage
supplementation scheme between 2008 and 2013, but also the steady increase in
the number of part-time workers to nearly 18% of total employment in 2013. In
particular, the share of involuntary part-time workers rose from around 40% at
the onset of the crisis to nearly 62% in 2013. ([2]) These developments helped to contain the rise in unemployment but
may also have slowed down the reallocation of resources and indicates that
labour market distress in Italy during the crisis increased more than when
measured only by unemployment figures. The number of persons available for work
but not actively seeking it – commonly referred to as 'discouraged workers' and
not considered as unemployed – also increased substantially during the crisis.
This implies that a wider measure of under-employment (including both
‘discouraged workers’ and ‘involuntary part-time workers’) went up to about one
fourth of the labour force. It must be noted that the measure of ‘discouraged
workers’ has always been higher in Italy than in other countries, and may hide
undeclared workers. The younger generations have been particularly affected by
the crisis: in 2013, the youth (aged 15-24) unemployment rate was 40%, while
around one in five youngsters was reported not to be in employment, education
or training. The Commission Forecast expect a further rise in the unemployment
rate in 2014 and a marginal decline in 2015, as the recovery is slow and
improves employment prospects with some lag.
Social hardship has increased. Between 2008 and 2012, Italy recorded the fourth largest increase
in the EU in the share of people at risk of poverty or social exclusion
(AROPE), which rose from 26% in 2007 to around 30% in 2012. Regional
disparities matter: AROPE scores are significantly higher in southern regions
than in Italy as a whole. In addition, poverty entry and exit rates are
respectively high and low, indicating the presence of poverty traps. 
Reforms and implementation
The Italian authorities have adopted
several measures to respond to the crisis and enhance potential growth. In 2011-12, Italy has adopted important structural reforms
alongside the considerable fiscal consolidation efforts. The labour market
reform (see Box 3.2) and especially the pension reform were the most important
actions taken. Other relevant measures concerned the reform of the recurrent
taxation on property, the introduction of an allowance for corporate equity
(ACE, which was recently further strengthened), action in the area of civil
justice as well as the liberalisation of professional services and energy
sector. 
The pace of reforms is slow and their
impact has been reduced by sluggish implementation.
More recently, other measures of more limited ambition have been taken in
various areas. Some simplification and market opening measures (particularly in
network industries) are positive steps to build a more growth-friendly business
environment, but only limited action has been taken to support further market
opening in the services sectors. Taxation has somewhat shifted away from labour
and there has been a reform of the tax deductibility of banks' loan loss
provisions, but the announced revision of cadastral values and the reduction of
tax expenditures have not been implemented yet. On education, recent efforts
are limited with respect to the challenge that Italy faces regarding human
capital (see Section 3.3). There are also delays in implementing the system for
the evaluation of schools. Decisive action to improve the effectiveness of the
public administration is lagging behind. This in turn weighs on the effective
implementation of new reform initiatives, in particular because of insufficient
coordination between government layers.
 (Continued on the next page) 
 Box (continued) 
 (Continued on the next page) 
 Box (continued) 
Stagnating productivity is at the root
of Italy's loss of external competitiveness and weighs on the sustainability of
the high public debt. Simultaneously reducing
public indebtedness and improving external competitiveness is very challenging
because, while nominal wage moderation could help to recover cost
competitiveness in the short term, it would weigh on the country's debt
dynamics. ([3]) Hence, a
durable correction of Italy's imbalances and an increase in the overall
resilience of the economy critically depends on the evolution of productivity
growth. Boosting productivity growth, however, requires tackling inefficiencies
in the allocation of both labour and capital, while addressing insufficient
human capital accumulation. This however can only happen in the longer term,
which is why decisive policy action is required.
3.1.      High
public indebtedness
High public debt is a major source of
vulnerability for the Italian economy. The very
high government debt holds back economic growth through several channels,
especially because its growth has not financed a correspondingly elevated
accumulation of human and physical capital endowments. A first channel is the
present and expected future high level of taxation needed to service debt which
dampens domestic demand and comes with distortionary costs. In particular, the
heavy taxation of labour and capital in Italy weighs significantly on growth.
Second, Italy's high interest expenditure – 5.3% of GDP in 2013 – limits the
room for productive public expenditure. Third, high public debt limits the
government's fiscal space to respond to economic shocks. Fourth, high
government indebtedness makes Italy more vulnerable to sudden increases in
sovereign yields and financial-market volatility, which in turn affect the real
economy. Finally, large annual sovereign debt roll-over needs – in the order of
25% of GDP – expose Italy to substantial refinancing risk, in particular in periods
of increased risk aversion.
Fiscal policy complacency after euro
adoption contributed to a weak starting position of Italian public finances at
the beginning of the crisis. Italy undertook a
major fiscal consolidation in the run-up to euro adoption: high primary
surpluses drove most of the decline in the public debt-to-GDP ratio. After the
introduction of the euro however, Italy benefitted from considerably lower interest
expenditure, but did not maintain the large primary surplus needed to reduce
the debt‑to‑GDP ratio at a satisfactory pace. Moreover, the
beneficial effect of real GDP growth was rather small (Graph 3.1). As a result, over the period
1999-2007, Italy's public debt ratio declined by only 11 pps. to 103.3% of
GDP at end-2007 from 114.3% at end-1998. ([4]) Since the start of the crisis, the debt ratio has been steadily
increasing. During the first phase (2008‑10), the increase in the debt
ratio was driven by negative real GDP growth and the erosion of primary
surpluses. In the second phase (2011-13), interest expenditure increased owing
to the higher risk premium, while real GDP continued to contract. At the same
time, Italy's contribution to the financial assistance to euro‑area
programme countries and the settlement of government trade debt arrears – both  captured
by stock-flow adjustments – raised the debt ratio further (by around 3.6% and
1.4% of GDP respectively). However, higher primary surpluses - as a result of
rapid fiscal consolidation in response to sovereign debt market turmoil –
curbed somewhat the increase in the debt ratio, which is estimated to be just
below 133% of GDP at end-2013.
 (Continued on the next page) 
 Box (continued) 
Italy's general government debt-to-GDP
ratio is expected to peak at around 134% in 2014, and decline slightly in 2015
thanks to the higher primary surplus and nominal GDP growth. Under strong financial-market pressure, the country implemented
significant fiscal consolidation measures over 2011-13, which averted immediate
sustainability risks thanks to the stronger fiscal position achieved
(structural primary surplus estimated at around 4½ % of GDP in 2013). Italy
also undertook an ambitious pension reform, which – once fully implemented –
will have a beneficial effect on the medium-to-long term sustainability of
public finances. These national efforts were essential to make effective the
measures taken at euro-area level to strengthen the EMU's architecture and
remove redenomination risk. As a result, the sovereign risk premium has
substantially declined in recent months and is now close to pre-crisis levels. 
Putting the government debt‑to‑GDP
ratio on a satisfactory declining path will be a continuous challenge. Stylised simulations show that high primary surpluses and sustained
growth are necessary to put the debt‑to‑GDP ratio on a satisfactory
declining path, meeting the Stability and Growth Pact's  (SGP) new debt
benchmark (Box 3.1). Both conditions are challenging.
The increase in the sovereign exposure
of Italian banks makes them more vulnerable to public finance developments. During the euro-area sovereign debt crisis, domestic banks'
exposure to the Italian sovereign has increased significantly (see Box 2.1).
The strong rise in Italian banks' holdings of domestic government debt has
supported sovereign securities after the exit of private foreign investors
since mid-2011. This higher exposure has however increased the vulnerability of
the banking sector to developments in sovereign yields in the absence of a
complete banking union. In recent months, thanks to the stronger fiscal
position achieved and the improving euro-area financial framework, yields on
Italian sovereign-debt have fallen significantly and foreign private investors
have been gradually returning. Finally, Italy's public debt management
continues to be very effective in handling market expectations, also thanks to
careful communication, and auctions have continued to be successful. 
3.2.      Loss
of external competitiveness
The significant loss of external
competitiveness weakens Italy's growth prospects.
Italy's current account has recently improved sharply, but the turn-around
appears to be driven by a structural decline in potential growth and the
associated weak domestic demand, rather than a recovery of Italy's export
position. Despite some recent resilience in exports to non-euro-area countries,
Italy continues to suffer from weakening cost competitiveness and an
unfavourable product specialisation, reflected in the country's relatively
large decline in export market share, especially vis-à-vis the euro area. The
overall weakening of Italy's export position does not only imply a reduced
ability to exploit external demand as a source of domestic growth, but also a
gradually eroding capacity to pay for imports, in particular of energy for
which Italy is structurally dependent on foreign suppliers. A weakened export
position could eventually lead to renewed external deficits, which would again
expose Italy to the risk of a sudden reversal of foreign capital inflows.
3.2.1.   Export
performance 
Since euro adoption, Italy has been
subject to significant export market share erosion.
Between 1999 and 2010, the volume of Italian exports on average increased by 2%
per year, significantly below the 4.2% average annual growth recorded for the
euro area as a whole (Graph 3.2). This weak export performance has
implied a loss of export market share, which is larger than the market share
erosion recorded by other European countries (Graph 3.3). ([5]) Since 2010, the gap between Italy's and some European peers'
average annual export volume growth narrowed somewhat: over the period 2010‑13,
average annual growth of Italian export volumes stood at 2.7% versus a
euro-area average of 3.4%. In parallel, the loss of Italian export market share
in value terms stabilised in 2010 after the first phase of the global financial
crisis, but the country still underperformed compared to some European peers –
in particular Spain – which managed to expand their export market share. 
Italy's loss of export market share was
particularly acute over 2008-09. The decline of
Italy's export volumes and export market share in 2008‑09 was more
pronounced than the one recorded by European peers. A significant part of those
large market share losses were recorded vis‑à-vis euro-area trade
partners, and virtually no recovery took place in subsequent years. In
contrast, over 2010-13, Italy's export performance in extra-euro-area markets
was particularly positive thanks to stronger demand and a relatively favourable
euro exchange rate (Graph 3.4). One explanation for this diverging
trend could be that larger and more productive Italian firms, which were
already able to export outside the euro area, managed to catch up with growing
demand from extra‑euro‑area markets, thereby maintaining their
market shares.
The still large share of low and medium‑low
technology exports exposes the country to strong cost competition. Although Italy's sectoral composition of exports has undergone
some changes – notably a modest shift from low-tech to medium-low tech goods
(Graph 3.5) – it is still biased towards
traditional sectors such as textiles, leather products and footwear, in
addition to scale-driven industries such as basic metals, foodstuffs, plastics,
stone, ceramics, cement and glass. ([6]) With the liberalisation of global trade, this export product mix
has increasingly exposed Italy to strong cost competition. Some Italian
exporters might have been able to maintain their market share by focusing on
quality and on product and process innovation, but the scale of this adjustment
process remained insufficient to offset the decline recorded by exporters in
other sectors.
3.2.2.   Developments
in current and financial accounts and net external position
Since mid-2011, Italy's current account
balance has corrected sharply and is now again in surplus, mainly due to a
strong decline in imports. Most of the correction
in the current account took place between 2011 and 2012, when net external
borrowing improved from 3% of GDP to just 0.1% of GDP. At the beginning of
2013, the sum of the current and capital account balance turned positive again
(on a 12-month cumulative basis), and for 2013 as a whole a surplus just below
1% of GDP is estimated. This improvement is to a large extent due to that of
the trade balance (Graph 3.6), in particular the non-energy component
of the goods balance. Around three quarters of the goods balance correction
over the period 2011-13 is due to a decline in nominal imports (by more than
10%), driven in particular by depressed domestic demand (Graph 3.8). Nevertheless, exports also contributed
to the improvement of Italy's external balance: they grew by 3.6% in nominal
terms over the period 2011-13, and were mainly driven by demand from outside
the euro area (see Section 3.2.1). Also, Italy's trade balance is quite
sensitive to fluctuations in energy import prices, given the structural
dependence on imported energy (the average current account deficit for Italy
over the period 2007-11 broadly overlapped with the average energy trade deficit).
While the ongoing diversification of energy sources could make the country
somewhat less vulnerable to energy price shocks in the future, high dependence
on imported energy is expected to remain a permanent feature of the Italian
economy. 
The correction of Italy's current
account appears to be mostly non-cyclical. The deep
and protracted recession in the country has constrained estimated potential
output. Hence, domestic demand and imports are not expected to fully return to
their pre-crisis level and trend. Although Italy's estimated output gap is
quite large (‑4.3% of GDP in 2013), the output gaps of the country's main
trade partners are also negative, implying that foreign demand for Italian
exports is still set to rise with trade partners' domestic demand when the
latter's output gaps close. Recent estimates ([7]) indicate that Italy's cyclically-adjusted current account
balance was broadly balanced in 2013. 
From a savings-investment point of view,
a sharp fall in investment contributed the most to the recent current account
correction. With the crisis, general government
savings as a share of GDP reached a low in 2009 mainly due to the work of
automatic stabilisers, whereas consumption smoothing triggered a sharp fall in
households' savings. Eventually however, the decline in private savings was
more than offset by the strong fall in gross capital formation due to the worsening
economic outlook and tightening credit conditions. Under strong market
pressure, the general government sector undertook a significant fiscal
adjustment implying higher public savings, and a reversal in the decline of
private savings also became visible in 2013 as households started to adjust
consumption to permanently lower income prospects (Graph 3.7). As a result, the current account
balance turned positive in 2013. In 2014-15, the Commission Forecast projects a
further increase in national savings due to the ongoing balance‑sheet
adjustment in both the government and the private sectors. At the same time,
gross capital formation is expected to increase as (external) demand prospects
improve and financial conditions gradually ease. Therefore, the current account
surplus is set to stabilise at just over 1% of GDP.
The sharp correction in Italy's current
account reflects the withdrawal of foreign private capital flows, but the
latter trend started to reverse at the end of 2012.
As of mid-2011, in the context of the euro-area sovereign debt crisis, foreign
investors drastically reduced their exposure to longer-term Italian sovereign
debt. Confidence-based contagion from the Italian sovereign to the Italian
financial system also triggered large cuts in interbank loans and non-resident
deposits with Italian banks and in foreign exposures to bonds issued by Italian
monetary and financial institutions (MFIs) (Graph 3.10). Private-sector funding was to a large
extent replaced by official-sector funding, notably by Italian sovereign bond
purchases by the Eurosystem under the Securities Markets Programme (SMP) for
around EUR 100 billion (around EUR 90 billion still to expire), and the strong
increase in Italian banks' dependence on Eurosystem liquidity provision. The
improved fiscal and external positions as well as the announcement of the ECB's
Outright Monetary Transactions (OMT) programme in September 2012 and steps
forward in completing the euro area's economic governance architecture were all
factors that contributed to a recovery of investor confidence. This is
reflected in lower spreads between Italian and German government bond yields,
some recovery in demand for Italian sovereign securities by foreign investors,
and renewed interest in Italian corporate equity and debt instruments. As a
result Italian banks' reliance on Eurosystem refinancing fell from a peak of
EUR 280 billion in February 2013 to EUR 230 billion at end-2013. Only the
negative trend in non-resident deposits and loans to Italian banks has not yet
reversed, but the pace of outflows has decreased significantly. At the same
time, Italian investors have been reducing their disposals of assets held
abroad, which took place to mitigate the effect of the foreign capital
outflows, and have been stepping up again their purchases of foreign equity
instruments (Graph 3.9).
Despite a gradual deterioration, Italy's
net international investment position (NIIP) remains moderately negative. Italy's NIIP has gradually deteriorated from -5% of GDP in 1999 to
around ‑28% in 2013 (Graph 3.11), a moderate level compared to the one
recorded in other vulnerable economies such as Spain (-93.4% of GDP), Portugal
(‑119.4%) or Ireland (-110.5% of GDP). The composition of the financing
of Italy's NIIP has however changed substantially since mid‑2011. The
NIIP is now also funded by the official sector, owing to ample liquidity made
available by the Eurosystem in order to address the liquidity crunch in private
interbank and capital markets which affected Italy and other vulnerable
euro-area economies. In the context of fragmented euro-area financial markets,
the large liquidity injection led to a large increase in Italy's TARGET2
liabilities vis-à-vis the Eurosystem (Graph 3.12). The overall net exposure of foreign
investors to Italy has however remained broadly stable. ([8])
 
Italy's experience in 2011-12 shows that
even a moderately negative NIIP can make a country vulnerable to a reversal of
foreign capital inflows, with negative knock-on effects on the economy. Italy has to some extent managed to regain market confidence in
recent months. Yet the country remains exposed to significant external
refinancing risk in case of renewed risk aversion among foreign investors to
finance its external liabilities, which are mostly in the form of debt
instruments. Eventually, when the Eurosystem's current full-allotment liquidity
provision ends, Italian banks' will also have to reduce their reliance on this
channel of financing. Going forward however, the achieved current account
surplus – if not reversed – would allow Italy to gradually reduce its negative
NIIP.
3.2.3.   Cost/price
competitiveness
Italy's external competitiveness has
been hindered by growth in unit labour costs which has outpaced that in other
euro-area countries. Over the period 1999‑2012,
Italy's unit labour costs (ULC) has increased by 2.4% per year on average. This
is above the euro-area average of 1.7% as well as the ECB's below-but-close-to
2% reference value for HICP-based inflation. Italy's relative ULC increase was
mainly driven by a negative trend in labour productivity growth (Graph 3.13) – also reflecting labour hoarding in
recent years – whereas nominal compensation per employee has grown broadly in
line with the euro-area average. The evolution of ULC relative to main trade
partners and the appreciation of the nominal effective exchange rate (NEER)
since the beginning of the 2000s together explain the appreciation of Italy's
real effective exchange rate (REER) based on ULC (Graph 3.14). ([9]) Ambitious reforms of the labour market and of the collective
bargaining mechanism were introduced in recent years and are now gradually
being implemented (see Box 3.2). These reforms can potentially foster a
better alignment of wages to productivity through wage differentiation that
appropriately addresses the large dispersion of productivity and labour market
conditions across the country. Ultimately, this is also expected to improve the
allocative efficiency of the economy and contain Italy's ULC growth through
enhanced productivity (see Section 3.3).
Price-based REERs suggest a less
unfavourable competitiveness position for Italy than ULC‑based REERs. Graph 3.15 shows the evolution of the REER of
Italy and some European peers based on producer prices (PPI) in manufacturing.
In 2012, the PPI-based REER level was still close to the level recorded at the
onset of the euro, despite the appreciation of the nominal effective exchange
rate (NEER). It therefore provides a better picture of Italy's competitiveness
than the ULC-based REER. Price-based REERs capture a wider range of production
costs beyond domestic labour, but may also be influenced by other elements such
as quality improvements and price-setting power. Giordano et al. (2013) argue
that nominal ULC may not be the most representative indicator of a country's
competitiveness. In particular, increasingly globalised value chains may imply
a decreasing share of domestic factors in total production costs as inputs
sourced from abroad increase at the expense of domestic labour. IMF
(2013b) adapt the REER framework to a world in which countries compete in the
supply of value added (or ‘tasks’, rather than goods) and also find that
Italy’s cumulative loss of competitiveness since euro inception is less
pronounced than when using ULC-based REER. ([10]) Nominal ULC however remain relevant as they signal the extent of
domestic cost pressures on prices and profit margins.
 
Wage moderation so far has been driven
by the public and non-tradable sectors. Graph 3.16 shows diverging dynamics in nominal
hourly compensation of employees by sector since the onset of the crisis.
First, it illustrates a decoupling of the index in nominal hourly compensation
for employees in tradable sectors from the corresponding index in the public
sector ([11]), which is
explained by the public wage freeze enacted by the government since 2011.
Second, it displays that also the other non‑tradable sectors experienced
more moderate wage dynamics than tradable sectors. This could be explained by
the weaker productivity dynamics in non‑tradable sectors. Graph 3.17
sheds light on ULC developments in the manufacturing sector, distinguishing
between exporting firms and other firms. It shows that, during the crisis, wage
growth has been more dynamic in exporting firms, while the opposite was true in
the pre-crisis period. However, as exporting firms have displayed higher
productivity growth than other firms in both periods, ULC growth has been more
contained. 
Contractual wages so far have been less
responsive to labour market conditions than actual compensation. There are considerable differences between the dynamics of actual
wages (hourly compensation of employees based on national accounts) and those
of negotiated hourly wages. Compensation of employees has been growing faster
than negotiated wages until 2008, driven by a positive wage drift. Since the
onset of the crisis however, contractual wages have been less reactive to the
negative economic cycle than actual wages, indicating negative wage drift.
Graphs 3.18 and 3.19 show the Phillips curves that relate
the unemployment rate to the growth of negotiated wages and to hourly
compensation of employees in national accounts respectively. In both graphs,
two curves are shown, one for the pre-crisis years 2005-08, and one for the
crisis period 2009-13. The Phillips curves based on actual wages indicate that
the almost flat relationship between the unemployment rate and wage growth
before the crisis changed into a negative relationship after the crisis. By
contrast, the Phillips curve based on contractual wages has flattened during
the crisis, indicating low responsiveness of wages to labour market conditions.
As indicated in Box 3.2, this may be related to some features of
the wage-setting system in Italy. It can be expected that contractual wages for
contracts due to be renewed in 2014 will adjust to lower expected inflation (at
end-2013, 32.4% of contracts needed to be renewed). 
Composition effects may mask some of the
ongoing wage adjustment. At the onset of the
crisis, the reduction in employment mainly affected workers on temporary or
atypical contracts, which are typically paid less than workers on regular
contracts. Meanwhile, the increase in retirement age enacted with successive
pension reforms has prolonged careers. As a result, between 2007 and 2012 the
share of people aged 50-74 in total employment increased by almost 5 pps. while
the share of young people (aged 15-24) diminished by 1.5 pps. Ceteris paribus,
this implies an increase in the average wage level because older workers are
usually paid more than younger ones (see Section 3.3). 
Real wages have been adjusting mainly
through a reduction in hours worked. Graph 3.20 shows annual growth in real
compensation of employees in the industrial sector (excluding construction)
over the period 2007-13, in both hourly terms and per employee. ([12]) As the economy contracted in 2008 and 2009 and working hours fell,
real wages per employee declined significantly. When working hours stabilised
and even slightly increased in 2010-11 thanks to the recovering economy, the
rise in real wages resumed. However, firms that hoarded labour in the first
phase of the economic crisis started to dismiss workers as of mid-2011 when the
economy fell again into recession. Since then, unemployment has risen steadily
from 7.9% in Q2 2011 to 12.3% in Q3 2013. In response to this, real wage growth
has decelerated, in both hourly terms and per employee. In particular, during
the second and third quarters of 2013, nominal hourly wages in manufacturing
have grown in line with inflation. Going forward, real wage adjustment may become
more difficult to achieve in a context of low inflation.
Shifting taxation away from productive
factors would make the tax system more growth-friendly, while improving cost
competitiveness in the short term. The tax burden
on labour in Italy is very high compared with the EU average. The implicit tax
rate on labour was 42.3% in 2011, the second highest in the EU and well
above the EU average of 35.8%. ([13]) The tax wedge for the average-wage single worker stood at 47.6% in
2011 and 2012, also above the EU average. In contrast, the implicit tax
rate on consumption in 2011 (17.4%) was below the EU average (20.1%). ([14]) Overall revenues from taxes on property were in line with the EU
average of 2.1% of GDP in 2011, with an elevated component stemming from taxes
on property transactions. In 2012, the recurrent component – which is
considered the least detrimental to growth – is estimated to have increased
from 0.7% to around 1.5 % of GDP. A small step in reducing the tax burden on
labour was taken with the 2014 budget while the standard VAT rate was increased
from 21% to 22% in October 2013. A further shift in taxation away from
productive factors in a budgetary neutral way would contribute to an
improvement in cost competitiveness in the short term and support labour and
capital accumulation. Although favourable, this fiscal strategy cannot be a
substitute for deeper structural reforms to enhance competitiveness since the
permanent effects of a tax shift are likely to be small in size. ([15]) In addition, it has to be noted that the scope to reduce the
labour tax wedge is constrained by the need to ensure adequate pensions under
the new contributory system, which closely links contributions paid and future
benefits.
A high cost of doing business further
weighs on Italy’s external competitiveness. Firms
operating in Italy are confronted with high input costs in several areas.
Italy's unfriendly business environment, public administration inefficiencies
and red tape, as well as high intermediate input prices, largely owing to
remaining barriers in sheltered sectors of the economy ([16]), weigh directly on firms’ cost competitiveness. Furthermore,
Italian companies – especially SMEs – face more difficult access to credit and
higher interest rates on new bank loans than their peers in other euro-area
countries (see Section 2). Finally, end users' electricity prices in industry
are among the highest in Europe, as a result of a combination of elevated
energy supply costs (the third highest in the EU, primarily due to heavy reliance
on imported gas) and high taxes and levies (the highest in the EU). The latter
reflect high subsidies for renewables and other unrelated  taxes and levies (oneri
impropri) included in the electricity bill. However, the good energy
intensity performance of Italian firms, among the best in the EU, imply that
the share of energy costs to gross output and to value added are in line with the
EU average, while increasing reliance on renewables will help reduce Italy's
dependence on imported energy. ([17])
The participation of Italian firms in
global value chains is relatively limited which may further constrain export
competitiveness. A higher participation in global
supply chains generally contributes to enhance export competitiveness as it
gives firms access to cheaper and higher-quality inputs. However, the share of
foreign value-added in Italian exports is among the lowest recorded in European
countries, indicating that Italian firms participate less in global value
chains than their peers in the rest of Europe (Graph 3.21), which may therefore weigh on their
export competitiveness. At the same time, it also implies that the eventual
recovery of exports would imply a smaller increase of imports. Italy's
relatively limited integration in international value chains may only be
partially due to the small size and lack of non-price competitiveness of
Italian firms, as SMEs can actually play a significant role in niche areas
(e.g. in the production of specific intermediate inputs for export). Italy's
unfriendly business environment, inefficient public administration and
inadequate human capital might also play a role in holding back inward foreign
direct investment which is often associated with the process of integration in
global value chains. ([18])
3.3.      Italy's
productivity challenge 
Italy’s dismal productivity growth is at
the root of the country's macroeconomic imbalances.
Italy’s total factor productivity (TFP) growth came to a halt at the end of the
1990s and has been subdued and even negative ever since. Weak productivity
growth hampers competitiveness, both through cost effects (affecting the
efficiency of producing a given item) and non-costs effects (product mix,
quality upgrading and after-sale services) ([19]). Stagnating productivity also entails low GDP growth (Graphs 3.22 and 3.23) which affects debt dynamics. 
Slow productivity growth is driven by
allocative inefficiencies. Long-standing weaknesses
in governance structures and public administration slow down the reallocation
of resources towards more productive sectors and firms. At the same time,
insufficiently developed capital markets hold back technological innovation and
absorption. Labour market rigidities and the education system hamper human
capital accumulation. Recent research indicates that such conditions deter FDI
and hamper firm-level productivity, in turn holding back the expansion and
internationalisation of firms. ([20]) Graphs 3.24 and 3.25 show Italy’s high share of small and on
average less productive firms in the manufacturing sector. Industrial
districts, a traditional feature of the Italian economy, help Italian firms to
partially compensate their size disadvantage through clustering. Firms within
industrial districts perform better in relative terms with respect to a range
of indicators, including turnover growth during the crisis, innovation and
internationalisation. ([21])
3.3.1.   Capital
allocation and innovation
Italy's investment rate is comparable to
that in other euro-area countries, but its level of capital efficiency is lower
and declining. Graph 3.26 shows that gross fixed capital formation
(excluding dwellings) in Italy is comparable to that of its peers, including
during the crisis when a sharp decline occurred (also relative to other GDP
components). While capital deepening has a continuous positive impact on labour
productivity (Graph 3.22), the observed accumulation pattern
does not seem to have led to rapid technological change and TFP growth, as
shown by the low and declining the marginal efficiency of capital in Italy
(Graph 3.27). ([22]) 
The quality of investment in Italy,
rather than its quantity, appears to be weak. Hassan
et al. (2013) provide tentative evidence of capital misallocation by showing
that there was no correlation between loan growth (the main source of
investment financing) and TFP across sectors over the period 1999-2007. Another
indicator of the limited ability of the economy to reallocate resources towards
more productive firms and sectors is the rather stable death rate of firms
against the background of falling birth rates (Graph 3.28). While pointing to some resilience in
Italy's productive system, this could also indicate inertia in the country's
allocative efficiency. ([23])
Technology absorption and innovation
remain low. Chart 3.29 (reproduced from Hassan et al. (2013))
analyses the composition of Italian investment, focusing on ICT. It shows that
Italy recorded shares of ICT in total non-residential investment similar to
France and Germany only until the mid-1990s. The economic literature provides
robust evidence that such differences in countries’ ability to absorb new
technologies, notably ICT, were at the root of divergent productivity
developments, within and outside Europe. ([24]) The low technology absorption and innovation capacity reflects the
traditional bias of the Italian economy towards low and medium‑low
technology sectors (Section 3.2). Private R&D spending in Italy is
particularly low (0.7% of GDP in 2012, compared to 1.9% in Germany and 1.3% on
average in the EU). The number of patents per million inhabitants is also low
(63.5 in 2011), half and less than a quarter of the French and German figure
respectively. The use of aggregate official statistics such as R&D
expenditure or the number of patents may underestimate the innovative efforts
of Italian firms, given the dominant presence of SMEs. For instance, Benvenuti
et al. (2013) show that 53% of Italian firms introduced some innovation over
the period 2008-10, only slightly less than in France and in line with Finland and
the Netherlands. However, evidence also shows that when product innovation is
taking place, Italian firms have a lower capacity to register patents and/or
designs, trademarks and copyrights. They also have lower shares of sales from
innovative products and lower shares of products that are new to the market
(and not only to the company itself). ([25])
Insufficiently diversified capital
markets may have contributed to this result.
Capital flows into low productivity activities in sheltered non‑tradable
sectors driven by rent-seeking rather than by efficiency considerations may in
part explain the inefficient investment patterns outlined above. ([26]) Some underlying drivers are discussed in Section 3.3.3. The
literature points to the role of insufficiently developed capital markets in
hindering structural changes in the economy and sustaining the growth of
innovative SMEs. The uncertain returns over a relatively long time horizon,
winner-takes-all effects, information asymmetries and the absence of collateral
imply that equity is more adequate than debt for financing innovation. In
particular, venture capital and funds from business angels – two specific forms
of private equity – constitute the main private-sector solutions to the problem
of financing innovation, in particular for small and start-up firms. The
financial structure of Italian firms, including the most innovative, is however
characterised by a higher incidence of bank loans than in other euro-area and
Anglo-Saxon countries (66% in 2012, compared to 50% and 30% respectively), which
is especially problematic in the current context of tight credit conditions. ([27]) The debt bias reflects inter alia the dominant role of banking in
financial intermediation, the relatively high share of Italian firms that are
wholly family-owned – which might imply reluctance to give up control through
equity issuance – and the underdevelopment of equity capital markets in Italy,
in particular the venture capital market (see Graph 3.30). These findings suggest that Italian
innovative start-up firms are more constrained in obtaining funding than
innovative companies in other European countries, limiting the innovative
capacity and reactivity of the economy as a whole.
3.3.2.   Human
capital accumulation
Human capital appears inadequate to the
needs of a modern competitive economy. In 2011,
Italy had the fourth highest share of population with only basic education and
the lowest share of population with tertiary education in the EU. Particularly
worrying are the low attainment rates for adults, but also for young cohorts
(Graph 3.31 and 3.32) pointing to a further widening of the
skill gap in the future. Similar evidence emerges regarding skills: notably in
the OECD PIAAC ([28]) Survey,
Italy ranks at the bottom in literacy among the countries participating in the
survey and only above Spain in mathematic skills. Moreover, Italy's results are
highly polarised. At the top end, only 3.3% of Italians reach the highest score
for literacy (OECD average of 11.8%) and 4.5% for mathematics (around 10% for
the OECD average). At the bottom, 27.7% of Italians have literacy competences
at or below the minimum level (OECD average of 15.5%). Older people score
particularly weakly, but the younger generation also underperforms.
Knowledge and skills of students differ
significantly across regions. In terms of quality,
according to the OECD's 2012 PISA ([29]) survey, Italy's 15 year-old pupils continued scoring significantly
below the OECD average across the reading, mathematics and science scales,
although results have improved compared to previous PISA rounds. ([30]) At the same time however, Italy fares relatively well in recent
studies of 10-years old pupils (concerning literacy and reading as well as
mathematical and science skills). ([31]) There are important regional variations in scores, with northern
regions faring generally better than southern regions and centre regions close
to Italy’s average. In PISA, for instance, students from Trento, Veneto,
Friuli-Venezia Giulia and Lombardy tend to have average scores well above the
OECD average. ([32])
Drop-out rates during both secondary and
tertiary education are high and adult education is not sufficiently developed. The percentage of 18-24-year olds leaving school without upper
secondary education was 17.6% in 2012, i.e. 5 pps. higher than the EU-27
average and still above the national target for 2020 (15-16%). In particular,
the drop-out rate is very high during the first year of upper secondary
education, revealing a difficult transition from the lower to the upper
secondary level. There are substantial regional variations: the rate varies
from around 15% in northern and centre regions to 25% in Sicily and Sardinia
(20% in the rest of the south). The drop-out rate is also very high at tertiary
level. According to OECD (2008), which contains the most recent data
(2005), the tertiary drop-out rate in Italy (55%) was the highest among OECD
countries. At later stages in working life, the participation of Italian adults
to formal and non-formal adult education and training is among the lowest in PIAAC
countries (24% of workers vs. the OECD average of 52%).
Public spending on education is below
the EU average, especially for tertiary education.
Italy’s public spending on education amounts to around 4.5% of GDP, 1 pp. lower
than the EU average, mainly due to lower spending on tertiary education. This
also reflects the lower-than-average attainment rates as spending per student
in purchasing power standard for ISCED 1-6 combined is broadly in line with the
EU-27 average. 
QUEST simulations show that human
capital weaknesses could explain a significant part of Italy’s productivity
gap. Results from the Commission's QUEST III
simulations to assess the impact of comprehensive packages of structural
reforms across EU countries (including spillovers) indicate that human capital
plays an important role in explaining Italy's productivity gap. Notably,
closing half of the gap to the three best performing EU countries in the
attainment rates at both ends of the skill scale could increase GDP by 8% over
the baseline in the long run. This represents nearly half of the potential gain
from the whole set of reforms simulated. Because of the relevance of cohort
effects to human capital reforms, Italy's gains from structural reforms over
the first 10 simulation years are smaller than for other countries. ([33])
The Italian labour market does not
appear to sufficiently value education and skills.
Returns to education are estimated to be lower in Italy than in other developed
countries. The OECD estimates that, for a man, the internal rate of return from
attaining tertiary education over secondary education is only 8.1% over the
lifetime, i.e. 5.5 pps. less than EU-21 average of 13.8%. For a woman, the rate
of return is 6.9%, compared to the EU-21 average of 12.1%. Internal rates of
return also create a disadvantage for men and women attaining upper secondary
education with respect to primary and lower secondary education. ([34]) This is consistent with available micro-econometric evidence
showing that an additional year of education in Italy increases current
earnings by about 5%, at the lower end of the 5-15% range reported in the
literature. Hanushek et al. (2013) calculate the return to skills using the
OECD's PIAAC results. They find that in Italy, a standardised increase in
numeracy skills is associated with a 13% wage premium for prime wage workers
(aged 35-54), lower than the 18% average and the fourth lowest among the OECD
countries covered by PIAAC (after Nordic countries, which have however a more
equal wage distribution). ([35])
Seniority matters more than education,
reducing incentives to invest in skills and education. Hanushek et al. (2013) find that in Italy, the return to skills for
older workers (those aged 55-65) is 12.3 pps. higher than for young adults
(aged 25-34), substantially outpacing the return according to cross-country
evidence. This is consistent with Italy’s age–earnings profile (Graph 3.33) which is flatter than in other
countries until the mid-40s and steeper only thereafter. Rosolia et al. (2007)
document a significant deterioration in real entry wages since the early 1990s
(although the level of education of new entrants was increasing), resulting in
increasing wage and life-time earnings differentials between those entered the
labour market before and after. They argue that this effect was primarily
driven by the successive reforms of the labour market that generated a dual
market where the burden of adjustment was borne only by (young) new
entrants. ([36])
There is also evidence of a difficult
transition from education to work. The ISTAT Labour
Force Survey's (LFS) ad-hoc module for 2009 showed that the average time between
leaving education and starting the first job was 10.5 months for Italy, second
only to Greece (13.5). Also, the share of NEET (young people aged 15-29 not in
education, employment or training) was at 24% in 2012, the third highest in the
EU. 
Vocational training shows important
shortcomings. At secondary level, vocational
training is developed but insufficiently work-based: the share of young people
studying and working at the same time is 3.9% vs. the EU average of 12.9% (Graph
3.34). The 2012 labour market reform
attempts to modernise apprenticeship contracts (Box 3.2), but professional apprenticeship
contracts (the most used) foresee only a limited education content (120 hours
in 3 years) and no educational or professional qualification, which limits the
potential of the reform to close the hiatus between the education system and
the labour market. At tertiary level, vocational training was missing until
very recently, which contributed to a large extent to Italy’s gap in attainment
rates for 30-35-year olds (Graph 3.35). Italy has recently introduced
tertiary-level vocational institutions, the impact of which will only be seen
in the future.
3.3.3.   Underlying
weaknesses in governance and public administration
Labour and product market regulations
have improved since the late 1990s, but the positive impact on growth has not yet
materialised. The OECD synthetic index for Product
Market Regulation (PMR) is now in line with the OECD average, while it was
among the most restrictive in 1998. Correspondingly, mark-ups in services have on
average declined substantially and are now among the lowest in the EU. ([37]) The OECD synthetic index for employment protection legislation
(EPL) also indicates that employment regulation in Italy is now less strict
than in France and Germany. ([38]) So far,
these reforms were however not sufficient to induce factor reallocation and reignite
productivity growth. While some barriers to competition in certain services
(including in professional services, retail distribution, postal services,
waste and local transportation) and rigidities in the labour market remain (as
discussed in Section 3.2), this also points to more fundamental issues that
hamper the functioning of labour and product markets irrespective of regulation
in place. ([39]) 
Progress in public administration efficiency,
including justice, and in improving the business environment has been limited. The World Bank's 2013 Worldwide Governance Indicators show that
Italy’s performance on the perception indicators relating to government
effectiveness, control of corruption and rule of law has been deteriorating
since 2000 and is among the lowest in the EU. ([40]). According to the World Bank's Doing Business indicators ([41]), Italy’s is among the worst EU Member States also with regard to
its business environment. In particular, starting a company remains very
costly, while contract enforcement and tax compliance are very
cumbersome. ([42]) Trade
potential is also hampered by slow and costly port procedures and lack of
adequate intermodal connections. In addition to the direct costs on businesses
(weighing on cost-competitiveness), an extensive literature shows that those
factors also have sizeable negative effects on growth by hindering FDI and firm
growth, constraining labour participation and hampering
reallocation. Giacomelli et al. (2012) for instance show that halving the
length of civil proceedings would increase the average size of firms by 8-12%.
([43])
Furthermore, there is evidence that inefficiencies in public administration,
and particularly the insufficient coordination between the different layers of
government, have hampered the effective implementation of adopted
measures. ([44])
Corruption and tax evasion remain
pervasive. The first EU anti-corruption report
highlights the extent of corruption in the country and analyses the underlying
drivers and consequences for the economy and for citizens’ trust in the
government and institutions. ([45]) Tax
compliance remains low and time-consuming for Italian taxpayers (269 vs. 178
hours on average in the EU for mid-sized companies in 2013) ([46]). An enabling law proposed in 2012 to enhance the tax system has
just been approved by Parliament. ISTAT (2012) shows that tax evasion/elusion
is larger in sectors characterised by very low productivity growth and a large
share of micro-enterprises, for which the possibility of evading/eluding
taxation represents a de facto disincentive to grow. ([47]) 
Firms’ governance and management appear
inadequate to foster productivity growth. The share
of family ownership in Italy (86%) is not highly different from the one
observed in France (80%) and Spain (83%) and even lower than in Germany (90%).
However, Italian family‑owned firms tend to be also family‑managed,
with limited recourse (only one third) to external managers. The recourse to
external managers is significantly higher in family‑owned firms in Spain
(two thirds), Germany and France (in both cases around three fourths). ([48]) Recent firm‑level research shows that the combination of
family ownership and management (as prevailing in Italy) tends to hinder good
quality management, which in turn hampers productivity-enhancing investment and
innovation (as reflected in the low penetration of ICT). ([49]) In addition, despite the progress in opening product markets to
competition, the scope of enterprises directly or indirectly controlled by
central, regional or local governments, remains important. There is some
evidence that such existing ownership and governance structures may not be
optimal. For instance, recent IMF stress tests ([50]) find that banks controlled by foundations are more vulnerable to
shocks than other banks and the Competition Authority points to inefficiencies
in local services (such as local transportation and waste) rendered by
companies owned by municipalities and operating under direct concessions.
3.4.      Euro-area spillovers 
Italy is deeply interlinked with other
euro-area countries. On the one hand, Italy’s
adjustment may have a deflationary and contractionary effect on the rest of the
euro area and its high debt increases the probability of renewed tensions in
sovereign debt markets through the confidence channel. On the other hand, an
overvaluation of the euro and a long period of low inflation also in non-vulnerable
countries would narrow the scope for price adjustment to recover
competitiveness and make it more difficult to reduce Italy’s debt-to-GDP ratio.
3.4.1.   Trade and financial linkages between Italy and the rest of
the euro area
Italy represents around 16.5% of overall
euro-area output and is tightly linked to other euro-area countries through
trade and financial links. Concerning trade links,
Italy is among the most important export markets for other large euro-area
economies such as Germany, Spain or France, as well as for neighbouring country
Slovenia. With regard to financial links, Italy's NIIP shows that in 2010,
France had a net asset position vis-à-vis Italy of almost 19% of its GDP, while
Germany, Luxembourg and the Netherlands together held net assets in Italy
amounting to around 7% of its GDP. Italian government debt held by other
residents of the euro area at the end of August 2013 amounted to EUR 711
billion, or 7.4% of euro-area GDP. This implies that any losses on Italian
assets would predominantly affect France and other euro‑area partners. On
the other hand, Italy held significant net assets in the rest of the world
amounting to around 17% of its GDP. 
Data on the cross-border exposures of
the banking sector show the crucial importance of Italy for the French banking
sector. Banking exposures constitute an important
share of the overall foreign asset/liability position. Gross liabilities of
Italian banks vis-à-vis French banks expanded at a fast pace in the run-up to
the financial crisis and are now at around EUR 250 billion, making France the
euro-area country with by far the highest exposure to the Italian banking
sector (amounting to almost 13% of French GDP) (Graph 3.37). Dutch, Austrian and German banks are
also significantly exposed, with claims on the Italian banking sector between
3% and 4% of the countries' respective GDPs. Outside the euro area, Switzerland
and the United Kingdom were the two most exposed non-euro-area European
countries at the end of 2012 (3.6% and 1.8% of their respective GDPs). The
exposures of banking sectors in non-European countries are more limited (Japan
for 0.7% and the United States for 0.3% of their respective GDPs). Gross
foreign claims of Italian banks are mainly towards banking sectors in other
European countries: Germany (11.8% of Italian GDP at the end of 2012), Austria
(5%), the United Kingdom (2.5%), Poland (2.4%) and France (2.3%). Non-EU
countries account only for roughly one quarter of Italian banks' foreign
claims.
3.4.2.   Italy's
imbalances and spillovers to the euro area
A fall in domestic demand in Italy
adversely affects euro-area partners. Graph 3.36 shows the relative distribution of
export losses in euro-area countries associated with sluggish growth in Italian
domestic demand (for instance, as a consequence of fiscal consolidation), based
on a simulation in an input-output framework using the recent World
Input-Output Database (WIOD). ([51]) Euro-area partners would be among the most affected countries. In
particular, stylized simulation of a 10% decline in Italian domestic demand
would lead to export losses well over ½% in Slovenia, Spain and France. 
On the other hand, structural reforms to
boost productivity and growth in Italy would have positive spillovers on other
euro-area countries. Simulations based on the
Commission's QUEST III model show that a comprehensive package of
growth-enhancing policy measures to bring Italy closer to best practices in the
euro area would boost Italy’s GDP and could have significant cross-border
spillovers to the rest of the euro area, although smaller than those from
demand shocks due to offsetting income and competitiveness channels (Graph 3.38). In the short-run, the reforms would increase
Italy’s domestic demand and increase exports from partner economies, therefore
boosting their economies. Countries that would benefit most from reforms in
Italy in the first two years would include France, Portugal or Cyprus (Graph 3.39). However, over the longer run, this
effect fades away due to relative cost, price and competitiveness position
adjustments. The simulations also show that the parallel implementation of
ambitious reforms across several Member States would overall imply cross-border
spillovers with potential synergetic effects. In Italy, these synergies would
lead to an additional increase in GDP of 0.2%, excluding any direct gains. ([52]) Therefore, reforms that enhance productivity and competition in
Member States would benefit the entire euro area. 
Italy’s high public indebtedness could
exert adverse effects on euro-area countries. The
transmission channel here is financial markets' sentiment and confidence. The
high debt level and the challenge for the government to put it on a downward
path in a context of low growth could create market uncertainty in case of
fiscal adjustment fatigue and/or further delayed reform action. Markets may
fret and spreads thereby widen again, as happened in 2011 at the height of the
sovereign debt crisis. Since then, the Italian government has however shown its
willingness to pursue fiscal consolidation, and yields have decreased
significantly. Recent analyses of determinants of sovereign spreads in the euro
area ([53]) ascribe indeed
an important role to the increase in general risk perception which particularly
affected the group of vulnerable euro-area economies, including Italy. This can
be seen in Graph 3.40 which shows the share of variance in
sovereign spreads in several euro-area countries accounted for by a common
factor. Following the establishment of the European Financial Stability
Facility (EFSF) and particularly the announcement of OMT, the co-movement in
spreads declined and Italian spreads progressively declined.
3.4.3.   Macroeconomic developments in the euro area and adjustment
in Italy 
Modest growth and prolonged low
inflation in the rest of the euro area make the adjustment in Italy more
challenging. Sluggish demand in Italy's main trade
partners, driven by both simultaneous fiscal consolidation in several other
euro-area countries and adjustment of excessive private indebtedness, makes
Italy’s turnaround in export performance more difficult. This is further
strengthened by zero-lower-bound constraints on euro-area monetary policy to
counter deflationary pressures and to prop up economic activity. Furthermore, a
prolonged period of inflation substantially below the ECB's medium-term target
of below-but-close-to 2% also in non-vulnerable euro-area countries would
reduce the room for price adjustment to recover competitiveness and make the
reduction of Italy’s debt-to-GDP ratio more challenging (see Section 3.1). 
The asymmetric adjustment within the
euro area and the resulting euro-area wide current account surplus could lead
to an appreciation of the euro exchange rate. Such
an appreciation could have a detrimental effect on intra-euro-area imbalances.
The simulations with the QUEST III model show that a sizeable real effective
appreciation of the euro would lead to a decline in Italian exports and also
output (Graphs 3.41). The effects of an appreciation
induced by internal euro-area factors, e.g. due to a reduction in risk
perceptions (Scenario 1 in Graph 3.42), would be bigger than those
originating from outside, e.g. as a result of monetary easing in the US and
Japan, (scenario 2) as in the latter case domestic demand and imports in the US
and Japan would increase, inducing higher demand for euro-area exporting firms.

Restoring dynamic and sustainable growth
remains the key challenge to reduce Italy's macroeconomic imbalances and the
risks they imply. As highlighted in this report,
Italy's growth over the last fifteen years has been disappointing and has
contributed significantly to the emergence of the two identified macroeconomic
imbalances: the high level of public indebtedness and the loss of external
competitiveness. Improving productivity is the first-best policy avenue.
However, the structural reforms required may take considerable time to bear
fruit. This suggests the possible need for complementary measures with
short-term impact.
Debt sustainability
Maintaining high primary surpluses over
an extended period is a condition sine qua non for the reduction of the
high public debt-to-GDP ratio. Thanks to the recent
fiscal adjustment effort, Italy managed to regain some investor confidence,
lower the country risk premium and reap the 'stability dividend' of progress
made at European level in strengthening the economic governance architecture.
Going forward, concerns about the sustainability of Italy's high public
indebtedness in a context of chronically weak potential growth may re-ignite
tensions in financial markets. Sustaining fiscal discipline by reaching the
medium-term objective (MTO) of a balanced budget in structural terms and
achieving and maintaining sizeable primary surpluses would help to put the
debt-to-GDP ratio on a steadily declining path and preserve investor
confidence.
Structural reform momentum
Given the magnitude and variety of
challenges facing the Italian economy, setting out a clear reform agenda with
detailed timelines and ensuring the full implementation of measures taken is a
matter of urgency. Italy has for too long postponed
much-needed structural reforms. The abated financial-market pressures in recent
months and the gradually improving economic outlook cannot leave room for
complacency. It appears therefore crucial that the sluggish and at times
ineffective implementation of approved measures is tackled. It seems also
essential that reform momentum is regained. Setting out a comprehensive reform
agenda, indicating priorities and milestones, would maximise policy synergies.
At the same time, ensuring a fair distribution of the burden of adjustment
appears to be a priority.
Swift and robust action to remove
barriers to the efficient allocation of resources would foster competitiveness
and growth. Removing remaining barriers to
competition and addressing long-standing inefficiencies in public
administration and the judicial system, also through the effective
implementation of measures taken, would be crucial to remove obstacles to
efficient resource allocation within the economy. It would also support the
creation of new (innovative) firms and enhance Italy's export capability,
thereby contributing to a dynamic and sustainable growth. Italy would also
benefit from improving tax compliance, reducing the shadow economy and fighting
corruption. Furthermore, there is significant room to modernise corporate
governance structures, both among publicly‑controlled enterprises and
private-sector firms, which are often family-managed. 
Investment and human capital
Future productivity growth will not only
depend on the quantity but also the quality of investment. The observed pattern of capital accumulation has not gone
hand-in-hand with dynamic productivity growth, while technology absorption and
innovation capacity remained low. The crisis led to a rapid fall in investment.
While demand prospects are slowly improving, restoring the flow of credit to
the real economy is important. Promoting the further development of capital
markets – in particular equity markets – would also help to improve the
allocative efficiency of the financial system and support productivity-enhancing
innovation. Attracting more FDI would allow the Italian productive system to
take advantage of transfers of knowledge and technology - enabling product and
process innovation - and would encourage modern corporate governance
structures.
Barriers to the efficient allocation of
labour and accumulation of human capital need to be removed. Further addressing labour market segmentation and allowing wage
differentiation to better reflect productivity and local labour market
conditions would improve the allocation of labour within and across firms and
sectors and provide the correct market incentives for human capital investment.
The education system could be made more inclusive and conducive to a smoother
transition to the labour market. Enhancing work-based learning and high-quality
vocational training would also be beneficial.
Restoring cost competitiveness
Labour cost moderation and a reduction
in the tax wedge on labour would have positive effects on Italy's external cost
competitiveness. In anticipation of the
materialisation of the beneficial effects of structural reforms on productivity
and growth, measures to alleviate pressures emanating from the cost side could
support external competitiveness already in the short term. Further
improvements to the collective bargaining framework to make wages more
responsive to productivity and local labour market conditions could be
explored, while closely monitoring the potential emergence of harmful
deflationary pressures and social distress. A decisive strategy to shift
taxation away from productive factors in a budgetary neutral manner and reduce
Italy's high labour tax wedge would equally help to moderate labour cost
pressures, while making the tax system more growth-friendly. In addition,
simplifying tax compliance and administrative procedures could also assist in
reducing the high cost of doing business and support external competitiveness.
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([1])  European Commission (2014d)
([2])  Involuntary part-time workers are
persons aged 15-74 working part-time but wishing and being available to work
more hours.
([3])  See for instance Fisher (1933) and
Darvas (2013)
([4])  In comparison, Belgium managed to
reduce its debt ratio by 33.2 pps. to 84% of GDP in 2007 from 117.2% in 1998, mainly
thanks to a primary surplus averaging 5% of GDP during the same 1999-2007
period (2.6% in Italy).
([5])  Italy's loss of export market share
expressed in value terms is slightly smaller than when expressed in volume
terms. Part of this difference might be due to a relatively strong increase in
Italy's export unit values, which may indicate that Italian firms have to some
extent been focusing on climbing the quality ladder. See for instance European
Commission (2012b) and IMF (2013b).
([6])  See for instance IMF (2013b).
([7])  European Commission (2014d)
([8])  De Grauwe et al. (2012)
([9])  IMF (2013c) for instance estimates that
in 2012 Italy's exchange rate could be overvalued by 0-10%, consistent with a
gap between the cyclically‑adjusted current account and the current
account consistent with fundamentals and desirable policies of 0-2% of GDP.
([10]) See for instance Giordano et al. (2013) and
IMF (2013b).
([11]) The public sector is represented here
by 'Public administration, defence, education, human health and social work
activities' as in NACE Rev. 2.
([12]) Real compensation is calculated by
using the gross-value-added deflator of industry excluding construction.
([13]) It would be even higher if the part of
the regional tax on economic activities (IRAP) weighing on labour were included.
([14]) The implicit tax rate on labour is
calculated as the sum of all direct and indirect taxes and social contributions
levied on employed labour income as a percentage of total compensation of
employees from national accounts. The implicit tax rate on consumption is the
ratio between the revenue from all consumption taxes and the final consumption
expenditure of households (European Commission (2013b)).
([15]) Koske (2013)
([16]) These elements and their impact on the
allocation of productive factors are further analysed in Section 3.3.1.
([17]) European Commission (2014a), European Commission (2014c)
([18]) OECD (2013b)
([19]) See ECB (2012) for an extensive review
of productivity and competitiveness relationships. 
([20]) See for instance European Commission
(2013a) and Altomonte et al. (2012). 
([21]) See for instance Intesa Sanpaolo (2013).
Within clusters, divergence among firms in terms of performance still exists.
([22]) The marginal efficiency of capital is
defined as the change in GDP at constant market prices of year t per unit of
gross fixed capital formation at constant prices of year t-5.
([23]) See also European Commission (2013d)
([24]) McMorrow and Roeger (2014), Inklaar et
al. (2008), Oulton (2010), Colecchia et al. (2001) 
([25]) Benvenuti et al. (2013), Bugamelli et al. (2012)
([26]) Balta (2013)
([27]) Bank of Italy (2013a), Magri (2007)
([28]) Programme for the International
Assessment of Adult Competencies; the survey is carried out among adults aged
16-65 in 24 countries.
([29]) Programme for International Student
Assessment
([30]) Italy's data at national level mask
very wide regional disparities: performance is in line with or above the OECD
average in northern regions but significantly worse in southern regions.
([31]) See the 2011 results of the Trends in
International Mathematics and Science Study (TIMSS) and Progress in
International Reading Literacy Study (PIRLS) by the International Association
for the Evaluation of Educational Achievements. 
([32]) Invalsi (2014)
([33]) Varga et al. (2013)
([34]) The private internal rate of return is
equal to the discount rate that equalises the real costs of education during
the period of study to the real gains from education thereafter. In its most
comprehensive form, the costs equal tuition fees, foregone earnings net of
taxes adjusted for the probability of being in employment minus the resources
made available to students in the form of grants and loans.
([35]) Hanushek et al. (2013) 
([36]) Rosolia et al. (2007)
([37]) Varga et al. (2013)
([38]) An analysis of the functioning and
reform of the labour market is carried out in Box 3.2 in Section 3.2.3.
([39]) European Commission (2013c), OECD (2014).
([40]) Available at www.govindicators.org.
([41]) The World Bank (2013)
([42]) Available at www.doingbusiness.org.
([43]) Giacomelli et al. (2012). See Esposito et al. (2014) for a review of studies on the economic consequences of an
inefficient civil justice system.
([44]) European Commission (2013c)
([45]) European Commission (2014b)
([46]) For VAT, a study commissioned by the
European Commission estimated that the tax gap (i.e. the difference between the
theoretical tax liability according to the tax law and the actual revenues collected,
as a share of theoretical tax liability) averaged 26% over the period 2000-11
placing the country in the fifth quintile across the 26 EU Member States covered
in the study. See CASE (2013). 
([47]) Istat (2012)
([48]) Accetturo et al. (2013)
([49]) Bloom et al. (2012), Bloom et al. (2007)
([50]) IMF (2013a)
([51]) Such an exercise takes into account the
complex inter-sectoral and inter-regional links, which is important to properly
assess the extent to which economy activity in one country spills over across
borders. On the other hand, this linear exercise fails to reflect the general
equilibrium effects and neglects other transmission channels for cross-border
spillovers such as FDI or other financial flows or labour flows.
([52]) Varga et al. (2013)
([53]) See for instance Giordano et al. (2012)