Italian cabinet announces surprise income tax cut to reboot economy

The Italian Stability Law for 2013–15, launched yesterday (9 October), sets out a mix of spending cuts and a new financial tax. However, it also delivers an unexpected twist, which is to lower the tax burden on struggling low-income households. After a prolonged cabinet discussion, a statement announced that Italy will reduce the income tax rates by one percentage point in the two lowest bands before the next general election scheduled for April 2013. This will signify a cut from 23% to 22% for those earning less than EUR15,000 (USD19,310) per year, and a drop from 27% to 26% for taxpayers earning an annual salary between EUR15,001 and EUR28,000. The top three rates will remain unchanged. In addition, the government has pledged to scale back the planned value-added tax (VAT) hike in July 2013 to 22% from 23%. This was preceded by a VAT hike from 20% to 21% on 17 September 2011.

With regards to the financing of the income tax reform, a new tax on financial transactions and "fiscal transactions" for banks and insurance companies will be implemented. Furthermore, the government plans will formulate a second round of health spending cuts, alongside yet-to-be-identified other state expenditure cuts (which could be lower subsidies paid to public and private sector companies), which are expected to raise EUR3.5 billion per annum. This will build upon the savings generated from the previous round of spending cuts announced in early July 2012, which are estimated at EUR4.4 billion in 2012 and 10.3 billion in 2013.

Key spending cuts proposed in July 2012

• Funding to central government ministries will be cut by EUR1.5 billion in 2012 and EUR3.0 billion in 2013. A major change will be the merging of the insurance and pension funds supervisors into a new body called IVARP that will regulate insurance and pension savings.

• Central government transfers to municipalities, regions, and provinces will be reduced by EUR2.2 billion in 2012, EUR5.0 billion in 2013, and EUR5.5 billion in 2014. The number of provinces will be cut by half from the current 110, and 10 new metropolitans will be created from 1 January 2014.

• The national health fund, which manages state health funds and distributes them to regional authorities, will have its budget trimmed by EUR1.0 billion in 2012 and EUR2.0 billion in 2013.

The government also plans to centralise spending controls over Italy's 20 regional governments, which have been the focus of a recent series of high-profile corruption scandals. This will entail tighter controls on spending on energy, tax collection, and the national transport network. Meanwhile, Italy will attempt to rein back the level of corruption blighting economic activity by creating an anti-corruption commissioner with investigative powers.

Outlook and implications

The drive to find alternative fiscal savings to allow the government to cut income tax rates for the low-paid alongside scaling back the impending VAT increase is an attempt to revive the ailing household economy. Indeed, household confidence continues to bounce around record lows, while overall spending fell by 2.8% year-on-year (y/y) and 3.6% y/y in the first and second quarters, respectively. Clearly, the deepening recession is being underpinned by a pronounced slump in consumer spending. Worryingly, recent consumer surveys have revealed that households remain very reluctant to spend as they struggle to cope with shrinking real household disposable incomes, unemployment close to breaking 11.0%, and the additional, painful revenue-raising measures passed during December 2011. A key concern is that households will save the additional income derived from the income tax cuts when faced with such a challenging outlook to their employment prospects and personal finances. The latest consumer confidence survey provides compelling evidence, with the sub-index measuring the willingness to acquire major consumer durables standing at an acutely depressing -103 in September. Despite the smaller VAT hike in July 2013 (leading to less pronounced drop in spending after the event) and proposed income tax cuts, IHS Global Insight remains downbeat about the near-term consumer spending outlook, but accept it will imply a moderate upward adjustment in our yet-to-be-released October forecast. Indeed, we now expect consumer spending to contract by 3.2% (revised from a 3.3% drop) in 2012 and 1.3% (from a 1.7% drop) in 2013.

Despite some welcome stimulus from the tax cuts, the overall economic outlook remains bleak, with struggling household and government spending and business investment expected to ensure that the recession has a long tail. Indeed, real GDP is estimated to have shrunk for the fifth successive quarter in the third quarter of 2012, while the latest survey data, namely the manufacturing and service-sector purchasing managers' index business and consumer confidence reports, suggest that the economy will continue to flounder in the remainder of 2012, spilling over into 2013. Furthermore, it could be undermined by the volatility generated around IHS Global Insight's baseline assumption that Greece will leave the Eurozone no later than the third quarter of 2013, anticipating a bumpy ride for the economy during over the second half of 2013. Overall, we currently expect real GDP to contract by 2.3% in 2012 and 1.2% in 2013, before stagnating in 2014 and resuming growth in 2015, according to our September forecast. Some positive effect from the pledged tax cuts and smaller VAT hike is expected to ease back the rate of contraction to 1.1% in 2013 in our yet-to-be-released October forecast.

Italy is confident that the new measures will not impinge on its goal to balance its structural budget by 2013, as agreed with its Eurozone partners. However, the Italian government has admitted that the recession is likely to be steeper than previously anticipated and will result in missed public sector budget deficit targets, according to the latest update of the state's Economic and Financial document for 2012–15 (DEF). The economy is now projected to contract by 2.4% in 2012, a marked downward revision from the previous official projection of 1.2%. In addition, the government now expects a further contraction in 2013, with real GDP projected to shrink by 0.2%, a notable shift from the earlier forecast of a 0.5% gain. The growth forecasts for both 2014 and 2015 have been raised slightly to 1.1% and 1.3%, respectively. The gloomier economic outlook has been reflected in softer public sector budget deficit targets, which are now expected at 2.6% of GDP (up from 1.7%) in 2012, 1.8% (up from 0.5%) in 2013, and will not balance in 2014 and 2015 as previously thought. The government has now accepted that its target of a balanced public sector budget in the next few years is unlikely, given that the recession is expected to have a long tail. However, Italy continues to argue that its latest fiscal developments remain consistent with the recently approved EU fiscal compact, which states that budget shortfalls should be adjusted for the business cycle. After factoring in the impact of the recession (automatic stabilisers and cyclical impact on tax receipts), the government expects its public sector budget deficit to be eliminated by 2013. With regards to fiscal developments, IHS Global Insight predicts that the public sector budget deficit will narrow from 3.9% in 2011 to 2.8% of GDP in 2012, 1.6% in 2013, and 1.4% in 2014, and will not balance until towards the end of the decade. This acknowledges the increasing pressures on the multi-year budget deficit reduction plan from the compelling signs that the recession is set to linger.

Reduced tax burden for low-income workers could soften trade union agitation

Part of the rationale behind this move is clearly to provide the government with some political cover ahead of the election in six months' time and to disarm possible trade union agitation. Going into the meeting, Susanna Camusso, the secretary-general of the powerful and militant CGIL trade union, explicitly threatened a general strike unless the concerns of low-income earners were addressed. Camusso has since described the Stability Law as a political ploy that will not alleviate the impact on ordinary voters who have been badly bruised by austerity measures. The other main trade union body, the more moderate CISL, has reacted cautiously but broadly favourably to the government's effort to soften the impact of austerity on struggling households. It is too early to say what the popular reaction to the measures will be. The likelihood is that they will not go far enough to appease large sections of disgruntled voters. However, even the "modest relief" on offer may have a psychologically uplifting effect. In presenting their plans, Prime Minister Mario Monti and Economy Minister Vittorio Grilli were mindful of the need to send a clear political signal that if the economic situation in Italy can be stabilised the potential benefits for ordinary Italians could become real. It has been received positively by the main political parties supporting the technocratic administration, meaning that the budget will have enough cross-party support in parliament to be passed.