Italy: The Path of Credibility Narrows
As the path to fiscal sustainability narrows, so does Italy’s political capital to credibly advocate a radical reform of EU fiscal rules. Italy's primary balance will need to improve by 0.9% of GDP each year in both 2025 and 2026: similarly sized improvements were recorded in only 3 of the 20 years before the pandemic (2 of which were at the height of the Eurozone crisis, in 2011 and 2012).
Over the next few months, EU fiscal policy will get back into the spotlight. The suspension of the Stability and Growth Pact (SGP) that was agreed during the pandemic will expire at the end of the year, and fiscal rules are set to be re-activated in 2024.
While it is safe to say that (almost) no one favours a return to the old regime, clarity is still very much lacking on what will replace it and the political deadlock on the reform of the EU fiscal framework persists.
The higher interest environment creates complex trade-offs for fiscal policy, which is bound to become an increasingly salient issue across the Union in the run up to the European Parliament elections. For Italy in particular, a lot is at stake in the reform of the SGP.
The Italian government’s recent revision of the country’s fiscal outlook is unlikely to play in Italy's favour, in the context of this delicate political discussion.
As the path to fiscal sustainability narrows, so does Italy’s political capital to credibly advocate a radical reform of EU fiscal rules.
As the path to fiscal sustainability narrows, so does Italy’s political capital to credibly advocate a radical reform of EU fiscal rules
A New Fiscal Landscape
The spirit of the reform of the EU fiscal framework published by the European Commission at the end of last year is to simplify the preventive arm of the SGP and increase the structural flexibility embedded in the system, while at the same time strengthening the role of incentives and the effectiveness of the corrective arm.
In the new regime, the flagship debt and deficit thresholds of 60% and 3% of GDP would be retained but the focus of fiscal policy would turn to net primary expenditure.
The path of net expenditure over the medium term would be anchored to debt sustainability, but the rule prescribing that debt in excess of the 60% Maastricht benchmark be reduced by 1/20th of the difference every year would be substituted by a dynamic debt reduction path.
As a compromise to mitigate the strong opposition manifested by Germany and other Member Sates, the Commission’s proposal includes a requirement fort the debt ratio to be lower at the end of the fiscal planning period than at the start, and suggests that for Member States in an Excessive Deficit Procedure (EDP) the growth of net expenditure should remain below medium-term output growth on average over the planning horizon.
For most EU members, the fiscal adjustment required under the new framework would be significantly less stringent than the alternative under the SGP rules.
For Italy, the medium-term adjustment would range between 2 and 2.7% of GDP under the new framework, compared to almost 5% of GDP under the current rules.
Overall, estimates recently published by Bruegel suggest the new rules would require Italy to improve its structural primary balance by around 0.9% on average each year over the 2025-28 period – against a much larger adjustment required to meet the currently suspended 1/20th SGP debt reduction rule.
The Path Narrows
The fiscal path recently published by the Italian government would fall short of the adjustment that would be required under the proposed new fiscal rules.
Media attention has focused on the upward revision of the deficit targets for 2023 and 2024 to 5.3% of GDP (from 4.5%) and to 4.3% (from 3.7%) respectively.
While the 2023 revision is largely due to higher than expected take up of tax credits under a construction incentive scheme, the 2024 target includes discretionary fiscal measures worth ca. 0.6% of GDP (mostly in the form of tax cuts).
The headline deficit is forecasted to return to the 3% Maastricht threshold only in 2026, and the debt ratio is forecasted to decline to 140.2% this year largely thanks to one off upward revisions of past year’s GDP, and hover at that level thereafter.
These projections come with downside risks. The debt stabilisation trajectory relies on the government raising approximately 1% of GDP from unspecified privatisations over 2024-2026, which appears ambitious in light Italy’s track record on similar measures. The GDP growth assumptions are optimistic compared to the latest forecasts by the European Commission, which see real GDP growth at only 0.8% in 2024.
While the Commission forecasts may be too conservative as they do not consider the discretionary measures included in the September update for 2024, the government may be too optimistic in its estimate of the positive demand effect of tax cuts at a time when global growth is softening.
Any undershooting in the growth numbers would negatively affect the differential between the cost of debt (‘r’) and nominal GDP growth (‘g’) – a key variable in the debt sustainability equation. (r – g) has been consistently positive in Italy over the past 20 years except for the last three, when high inflation helped shave off 15 points from the debt ratio. Under more ‘normal’ macroeconomic conditions, the differential is likely to turn positive again and a primary surplus will be required to stabilise debt.
The primary surplus planned by the government for the end of the forecast horizon (1.6%) is in line with the historical average over the 20 years before COVID (1.7%). But to get there, the primary balance will need to improve by 0.9% of GDP each year in both 2025 and 2026. This is an ambitious yearly adjustment by historical standards: similarly sized improvements in the primary balance were recorded in only 3 of the 20 years before the pandemic (2 of which were at the height of the Eurozone crisis, in 2011 and 2012).
As far as the structural primary balance is concerned, the budget update expects it to improve by 0.6% in 2025 and 0.5% in 2026, which would be below the 0.9% average annual adjustment that would be required under the new proposed fiscal framework for the 2025-2028 period.
For Italy, the medium-term adjustment would range between 2 and 2.7% of GDP under the new framework, compared to almost 5% of GDP under the current rules
Implications
Italy's recent budget projections show a weaker deficit and debt trajectory than previously expected. The upward revision of the 2023 and 2024 deficit has not yet triggered political tensions between Brussels and Rome.
The spread between the 10-year Italian and German bonds has widened markedly after the announcement of the revised fiscal outlook, but overall, the market reaction has remained relatively muted so far.
The already narrow path to fiscal stability however tightens , and the government’s room for discretionary measures in case of un-anticipated negative growth surprises is reduced.
The budget update also complicates the fiscal outlook going towards the re-activation of the EU fiscal rules.
Uncertainty remains on the final shape that the new fiscal framework will take, but the preliminary evidence presented here suggests that the path outlined in the recent budget update would fall short of the requirements under the proposed new rules – let alone of the very sizeable adjustment that would be required under the currently suspended SGP.
This is unlikely to be well received by Italy’s more conservative Eurozone partners and the Italian government may therefore soon be facing a difficult trade-off: its fiscal strategy may serve it well in delivering a good result in the European elections, but it is unlikely to play in Italy’s favour when the time will come to try and resolve the stalemate on the reform of the EU fiscal framework.
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
