Analysis: Italy's reform list reflects tough test for euro zone

LONDON Sun Oct 13, 2013 7:10am EDT

Italy's Prime Minister Enrico Letta attends a news conference in Lampedusa October 9, 2013. REUTERS/Calogero Lampo

Italy's Prime Minister Enrico Letta attends a news conference in Lampedusa October 9, 2013.

Credit: Reuters/Calogero Lampo

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LONDON (Reuters) - From its high labour taxes to its low literacy scores, Italy's entrenched obstacles to growth point up the enduring failure of some euro zone economies to adapt to the demands of life with no currency flexibility.

Protected by the European Central Bank's pledge to buy member states' bonds in an emergency, Italy has escaped market punishment for the political gridlock that has hampered reforms.

Nor is Italy the only reform sinner. France has been pilloried for its timidity in reining in pension and welfare spending. Germany has been under fire for years for not liberalizing its services sector.

But Italy stands out for many as the euro zone's weak link because of a toxic combination of high debt, low growth, fragile government and choking red tape.

Prime Minister Enrico Letta's coalition survived an attempt by former prime minister Silvio Berlusconi to wreck it, but he has little room for maneuver to tackle structural economic weaknesses.

"All the political ructions have done is thrown Italy's chronic economic and structural problems ... into sharp relief," said Nicholas Spiro with Spiro Sovereign Strategy in London.

BIG TAX WEDGE

At 133 percent of GDP and rising, Italy's debt stock is second only to Greece's in the euro zone, while growth has averaged just 0.7 percent a year in the past 20 years.

The economies of France and Germany might not grow much this year but Italy will be stuck in recession.

The optimistic view is that Italy's debt is sustainable even at very low rates of growth because the government has run a primary budget surplus - before interest payments - of about 2 percent a year for the past decade.

But rather than running ever greater growth-sapping surpluses, Italy needs supply-side reforms to improve its dismal productivity and raise its growth potential, which the International Monetary Fund estimates at just 0.5 percent a year.

With Italy ranked 30 out of 31 advanced economies by the World Bank in the ease of doing business, the IMF said in its latest health check on Italy that priority should be given to injecting competition into product markets and improving public services.

The Fund also urged cuts in taxes on capital and income to boost employment and growth.

It focused particularly on Italy's tax wedge - the difference between total labour costs to the employer and net take-home pay - which at 48 percent in 2012 compared with an average of 36 percent across the membership of the Organisation for Economic Cooperation and Development.

But a narrow focus on labour costs, important though they are, conceals as much as it reveals.

Germany is one of five countries, including Belgium, France and Austria, with higher tax wedges than Italy, according to OECD data. So labour costs are only part of the equation.

BROADER REFORM AGENDA

Ebrahim Rahbari, an economist with Citi in London, said high income taxes and social security contributions need not be a handicap if they go hand in hand with high productivity - as in Scandinavia - or are used to pay for first-rate infrastructure and public services that increase jobs and growth.

High wages need not be a problem either if matched by efficiency. And there's the rub. As Italian officials argued to the IMF, the steady deterioration in the country's unit labour costs relative to the rest of the euro zone is due not to excessive wage increases but to weak labour productivity, which has declined since the launch of the euro.

Just why Italy has underperformed for so long is hotly debated. The small size of Italian firms, the failure of business to respond to Asia's rise and the country's dysfunctional politics are among the culprits.

An OECD report last week highlighted Italy's poor basic numeracy and literacy skills, which are among the worst of any advanced economy.

But Italy has pushed through reforms that should have helped it adapt to the rigors of a single exchange rate.

Product markets have become less, not more, regulated; Italy's state-funded pensions regime is on a steadier footing since the retirement age was raised and contributions increased; and job market reforms in 2012 clarified dismissal conditions.

"They appear to be doing things if you look at some indicators, but we haven't seen the results," said Paul O'Brien, head of the Italy desk of the OECD in Paris.

"If you've got policy directed towards growth and it doesn't work, you start to ask questions."

BLAME THE STATE

O'Brien suspects the answer includes better legislation and implementing regulations, a more efficient public administration and a speedier judicial system.

"Legislative simplification and transparency will increase economic efficiency in themselves, while also making a contribution to reducing the incentives and opportunities for corruption and organized crime to flourish," he wrote in a recent working paper.

What are the chances of such deep-seated change with a fractious coalition government and in the absence of a bond market-induced crisis of confidence?

Rome recently issued a list of policies it has implemented or are in the works, but most economists are underwhelmed.

"Our expectation is that, with or without Berlusconi, the environment doesn't suggest that you have a mandate necessarily for reform," Citi's Rahbari said.

Italians need to price themselves back into work one way or another. Letta's ambition to cut payroll taxes by 5 billion euros next year would be a step in the right direction.

But Natacha Valla with Goldman Sachs in Paris doubted Italy's complicated politics would permit Letta to drive through further unpopular measures. "In our view, it is unlikely that large-scale reforms will be approved in the coming months," she wrote.

(Editing by Mike Peacock)

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