Identifier
Created
Classification
Origin
05ROME574
2005-02-22 09:14:00
UNCLASSIFIED
Embassy Rome
Cable title:  

Italy's 2005 budget - Smoke and Mirrors

Tags:  ECON EFIN ELAB PGOV IT KPRP ITALIAN POLITICS 
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UNCLAS ROME 000574 

SIPDIS


DEPT FOR EUR/WE, EUR/ERA, EB/IFB/OMA
PARIS ALSO FOR USOECD
TREAS FOR HULL
STATE PASS CEA
STATE PASS FRB FOR GUST
FRANKFURT FOR WALLAR
USDOC 4212/ITA/MAC/OEURA/CPD/DDEFALCO

E.O. 12958: N/A
TAGS: ECON EFIN ELAB PGOV IT KPRP ITALIAN POLITICS
SUBJECT: Italy's 2005 budget - Smoke and Mirrors

Ref: 04 ROME 4922

-------
SUMMARY
-------

UNCLAS ROME 000574

SIPDIS


DEPT FOR EUR/WE, EUR/ERA, EB/IFB/OMA
PARIS ALSO FOR USOECD
TREAS FOR HULL
STATE PASS CEA
STATE PASS FRB FOR GUST
FRANKFURT FOR WALLAR
USDOC 4212/ITA/MAC/OEURA/CPD/DDEFALCO

E.O. 12958: N/A
TAGS: ECON EFIN ELAB PGOV IT KPRP ITALIAN POLITICS
SUBJECT: Italy's 2005 budget - Smoke and Mirrors

Ref: 04 ROME 4922

--------------
SUMMARY
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1. For the last several years, Italy has relied on
extraordinary one-off revenue measures and spending
deferrals to avoid bumping up against the euro zone
budget deficit/GDP ceiling of three percent. Finance
Minister Siniscalco, a technocrat, has sworn off tax
amnesties and pursued the most challenging fiscal reforms
in the last decade, while also implementing Prime
Minister Berlusconi's long-promised tax cut. However,
domestic and international budget experts agree that the
2005 mix of spending and tax cuts, coupled with revenue
enhancements, will not keep Italy's deficit under the EU
ceiling, especially with prognostications now that GDP
growth rate will grow at best 1.4 percent, or even less.
The GOI will again need to turn to extraordinary
budgetary measures to accommodate another swollen budget
deficit, most likely after spring elections. End
summary.

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RECENT BUDGET TRENDS
--------------


2. For years, Italy's government spending has been high,
even by the standards of free-spending EU member states.
The result has been large public sector deficits financed
by debt. In the early 1990s, however, Italy started to
address its macroeconomic problems to qualify for first-
round EMU membership. Nonetheless, even at the end of
the virtuous path of the nineties, the public sector
deficit (as a percentage of GDP) was still dangerously
close to the three-percent EU Stability and Growth Pact
ceiling. In July 2004, to avoid a EU Commission Early
Warning, Italy implemented a 7.5 billion euro deficit
reduction package to bring the 2004 deficit in line with
the three-percent ceiling. On December 29, 2004,
Parliament approved the 2005 budget, totaling euro 645.4
billion (or 45.8 percent of GDP, down from 47.8 percent
in 2004). On the surface, the 2005 budget incorporates
one of the most aggressive deficit reduction packages in

the last decade and seeks both 24 billion euro (or 1.7
percent of GDP) in spending cuts and revenue increases to
shrink the budget deficit/GDP ratio to 2.7 percent.


3. The level of public debt, the highest as a share of
GDP within EMU countries and the second largest of
industrialized countries, has started to decline, but
still remains over 100 percent of GDP (105.8 percent of
GDP at end-2004, down slightly from 106.2 percent at end-
2003). Budget drafters think this ratio will not fall
below 100 percent before end-2007.

--------------
BUDGET/GROWTH ASSUMPTIONS TOO OPTIMISTIC
--------------


4. The IMF estimates 2005 GDP growth at 1.7 percent,
while the GOI estimates 2.1 percent. The Fund warns its
projected lower growth, if not offset by further deficit
reduction measures in 2005, could lead Italy to overshoot
the GOI 2.7 percent budget deficit/GDP target and perhaps
even the euro zone three-percent budget deficit/GDP
ceiling. The European Commission also questions Italy's
budget assumptions and predicts a deficit exceeding the
three-percent ceiling in 2005 and 2006. The Commission
also believes that 2005 tax cuts are not offset by enough
structural spending cuts. Finance Minister Siniscalco,
however, has underscored with the EU the GOI commitment
to keep the budget deficit/GDP ratio below three percent.


5. If economic performance continues as lackluster in
2005 as it was in 2004, even the IMF growth projections
will be hard to hit. Preliminary data indicate a 0.3
percent decline in GDP in fourth quarter 2004. This is
the first negative quarter-to-quarter result since second

quarter 2003, and the worst quarter-to-quarter
contraction since 1998. This fourth quarter performance
reflects weak Italian exports and a struggling industrial
sector, especially in the textile, leather, footwear, and
car sectors. Industrial production is technically in
recession for the last two quarters, and it indicates a
weak economy with no prospect for strong short-term
recovery. The original GOI assumption of 2.1 percent
growth in 2005 now appears too optimistic, as does the
IMF estimate of 1.7 percent. However, even the more
conservative 1.4 percent projected by The Economist
appears unrealistic, given negative fourth quarter 2004
performance. This situation should force the GOI to
rethink its budget strategy for 2005 and consider the
possibility of GDP growth in 2005 slightly higher than
the modest 1.1 percent return in 2004.

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EFFECTS OF TAX CUTS AND TAX INCREASES
--------------

THE FACTS
--------------


6. The 2005 budget includes a 4.2 billion euro tax cut to
increase disposable income and stimulate domestic demand.
The tax cuts provide for three brackets (23, 33, and 39
percent) instead of the previous five (with the highest
personal income tax level at 45 percent). Cuts are to be
funded in several ways. First, for 2005 only, a four-
percent "solidarity contribution," or tax surcharge, will
be levied on incomes above 100,000 euro. In addition,
there are also increases in indirect taxes and a utility
rate increase. Further, the GOI will increase stamp
taxes on some transactions, including, banking, boat and
real estate purchases. Higher stamp taxes will increase
taxes up to 30 percent on real estate and boat sales,
fishing, and trademarks. According to a leading consumer
association, these tax increases will result in an
additional tax burden on households of some 50 to 60 euro
a year.

ANOTHER VIEW
--------------


7. Italian private think tank CER estimated that 2005 tax
cuts would have a 0.2 percent positive impact on GDP
growth, and a 0.5 percent increase on consumption -
although these effects would be mostly offset by
inflation. Further, tax cuts will disproportionately
benefit higher-income households, as tax cuts did in

2003.


8. In addition, increasing other taxes to off set income
tax decreases does not come without a secondary cost.
This creates uncertainty among consumers/tax payers,
which could cause them to be more cautious about future
spending, thus dampening the expected stimulus of the tax
cut. In the case of real estate, the tax increase will
have a further negative impact on consumer confidence.

--------------
FOREIGN ASSISTANCE
--------------


9. Severe budget difficulties forced the GOI to reduce
its foreign assistance budget for 2005. As a percentage
of GDP, Italy's 2005 aid budget equals 0.08 percent, down
from the 0.11 percent in 2004. While GOI-pledged funds
for Tsunami relief (euro 70 million) are just a different
allocation within the 2005 appropriation, the euro 31
million debt relief to Indonesia and euro 7.2 million
debt relief to Sri Lanka, are not reflected in these
figures.


10. Comment: Italy's foreign assistance has not always
been this low. In the early nineties, Italy's aid budget
was 0.42 percent of GDP; but in 1992, to get finances in
order for Economic and Monetary Union (EMU) membership,
then-PM Amato more than halved Italy's foreign assistance

to 0.2 percent. Outlays have hovered close to the 1992
levels since then, partially due to the overall budget
strictures of EMU membership. Now, Italy limits its
assistance to a few key regions. For this reason,
Italy's GOI Monterey Summit commitments in 2000 to
increase its Foreign Assistance/GDP ratio to 0.7 percent
should be seen as a longer-term goal. End comment

--------------
DEFENSE
--------------


11. (Note: The "defense function" includes the budgets of
the Army, Navy, and Air Force, but excludes domestic
security and other non-essential MOD budget functions.
"Defense function" is the largest part of MOD funding.
Peacekeeping operations are a separate budget item
outside of "defense function." End Note.)


12. FY 2005 MOD funding totals Euro 19.0 billion, down
4.0 percent, or 790 million Euro, from FY 2004 funding
(19.8 billion Euro). As a percentage of GDP, 2005 MOD
funding amounts to 1.35 percent of GDP, compared to 1.47
percent in 2004. (In real terms, assuming a 2.0 percent
inflation rate in 2005, the 2005 MOD appropriation is a
six-percent decrease from 2004.) The 4.0 percent
decrease in total MOD funding includes a 3.7 percent
decrease in "defense function." In terms of GDP, defense
function equals 1.0 percent of GDP in 2005, compared to
1.1 percent of GDP in 2004. This ratio is lower than
that for the UK, France, and Germany. (Note: the GOI had
earlier committed to increase the defense function
funding/GDP ratio to 1.5 percent by end-2006. Later,
however, due to continuing budgetary problems, the target
became, more realistically, a medium-long term one. End
note.)


13. Comment: Continuing budget constraints might have a
negative impact on funds for armed forces modernization
projects and multi-year commitments. One result is that
Italy would be looking for smaller/less costly projects.
For its part, the military will sell off Euro 1.2-1.3
billion in property this year in an effort to maintain
capabilities. Funds deriving from the sale of military
real estate will be earmarked for future military
appropriations. End Comment.

PEACEKEEPING
--------------


14. As mentioned above, peacekeeping funding (for
Italy's military missions in Afghanistan, Ethiopia and
Eritrea, Sudan, the Balkans, Hebron, and Iraq) is
separate from both MOD funding and defense function
funding. If we were to add total 2005 MOD budget funding
(Euro 19.0 billion) to peacekeeping funding (Euro 1.26
billion, assuming the same level as that for 2004, total
defense spending for 2005 would then be USD 20.3 billion,
or 1.44 percent of GDP.


15. Note: The Treasury budget department (Italy's OMB-
equivalent) has confirmed that the 2005 budget includes a
euro 1.26 billion appropriation for Italian peacekeeping
missions, the same level set in the 2004 budget.
However, the Government and Parliament must together
agree on how this money will be allocated among the
various peacekeeping missions. End Note.

--------------
THE TWO-PERCENT GOVERNMENT-SPENDING CAP
--------------


16. One of the pillars of the 2005 budget strategy is a
two-percent government-spending cap to trim 1.93 billion
euro of the total 9.5 billion euro in spending cuts
included in the 2005 budget. According to a
"confidential" Central Bank document, the cap will not be
entirely effective; and, for this reason, public sector
spending (net of interest payments) is expected to
increase by 2.6 percent in 2005. The two-percent cap

will not apply across the board, but just on current
spending.

--------------
PRIVATIZATION
--------------


17. The 2005 budget does not provide details on the GOI
plan to raise euro 100 billion over the next four years
through privatizations of state-owned firms and, in the
process, to reduce the debt/GDP ratio from 105.8 percent
in 2004 to a target 98.8 percent in 2008. However, as
market conditions improve, we expect the GOI to sell off
assets again. This year, privatizations could involve
ANAS, the State road agency and GOI real estate holding
company. The GOI may also sell some of the defense
holding companies, Finmeccanica and Terna. Another
possibility would be to spin off part of Wind, the
integrated communications company (fixed, mobile,
internet),owned by ENEL, and thus indirectly by the GOI.
Finally, the GOI could privatize RAI, the wholly owned
GOI TV and radio firm, before yearend.

--------------
COMMENT
--------------


18. The EU, OECD, IMF, and Bank of Italy have all
expressed concern that the budget deficit will exceed
three percent of GDP in 2005, and that supplemental
measures will be needed. It is difficult to speculate
what those measures might be - one-time measures,
spending freezes, sale of real estate, etc. The IMF has
suggested covering the budget shortfall, euro 6 billion
by their estimates, by having consumers pay for some
usually free medicines and public services and by
implementing a public-sector wage cap -- both tough sells
in an electoral campaign season.


19. Looking ahead to 2006, despite EU and IMF remarks on
the impact of tax cuts on the three percent deficit/GDP
ceiling in 2005, the GOI is still planning a twelve
billion euro tax cut for 2006, reducing tax brackets from
three to two, eliminating the four-percent tax surcharge
for income exceeding 100 million euro. While promising a
2006 tax cut will be an important plank in the electoral
campaign for spring 2005 regional elections and for
spring 2006 national elections, the GOI must still come
up with politically-expedient spending cuts to at least
partially finance 2006 tax cuts. End comment.

SEMBLER


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2005ROME00574 - Classification: UNCLASSIFIED