We take a look at the 2020 budget just drafted by the Italian Treasury, and due to be submitted to Brussels this week. While the drafting has been complicated and rushed due to the summer political events, we think that the government could have been more ambitious.

The VAT hike is avoided but the offsets for 2020 are vague and uncertain. The interest cost of Italian debt is now at historical lows, and the government could have capitalized on this opportunity better, in our view. The pension reform and the flat tax could have been scrapped or reviewed at a relatively low political cost.

All in all, the headline deficit is not very different from the one in the budget passed by 5S and Lega one year ago, with the main difference being a more European-friendly attitude. This is an important feature, but it could have been exploited better. The current numbers still expose Italy to risks if global interest rates start rising or political uncertainty picks up again.

 

Starting point: 23 bln needed

The previous government started its term by rejecting EU fiscal discipline. The budget sent to Brussels in 2018 featured a large fiscal expansion, lowered only after the intervention of the European Commission and the threat of an Excessive Deficit Procedure (EDP).

The size of existing VAT safeguard clauses – which automatically kick in absent alternative funding options – was widened to 23 bn (1.3% of GDP) in 2020 and 29 bn (1.5% of GDP) in 2021.

These clauses would bring the VAT rate from 22% to 25.2% in 2020 and 26.5% in 2021 – with an estimated negative effect on GDP of 0.4 and 0.6 percentage points respectively. This “borderline compromise” – to quote Commission Vice President Dombrovskis – delayed all difficult fiscal decisions to 2020 and beyond. The incoming M5S-PD government thus inherited a very thorny budget outlook.

2020 budget: all about quick fixes

The underlying rationale for the existence of the current M5S-PD coalition is avoiding the VAT hike and reconciling the relation with Brussels. The 2020 budget reaches both targets, but details on the composition are scarce, leaving an element of uncertainty for 2020. The headline numbers of the 2020 budget are relatively conservative, with a headline deficit of 2.2% next year, 1.8% in 2021, and 1.4% in 2022. A deeper look reveals a shakier picture.

First, the budget is scant on details regarding the composition of the deficit. More will be set out in as many as 23 forthcoming law decrees, leaving a significant element of uncertainty. The VAT hike is avoided and funded (costing 1.3% of GDP), 0.1% of GDP is earmarked to renew measures carried over from past years, and 0.15% is the estimated cost of the promised reduction in the labour tax wedge.

Second, the offsetting of expansionary measures are vague and uncertain. The spending review element remains small (0.1% of GDP), so that the offsetting largely relies on new measures to fight tax evasion and fiscal fraud (0.4% of GDP). Revenues from the latter must be taken at a discount, as their success in the past has been mixed, and the tax fraud problem is a structural issue for the Italian economy, whose solution would require more radical measures.

Third, the effect of privatizations is substantially reduced, from 1% to 0.2% of GDP, probably due to the swing to the left of the new government. This means that the impact of the privatization plan proposed by the old government has been de facto inexistent.

The elephant in the room: interest costs

A key offset in the budget is lower interest costs. This accounts for modest savings in 2020 but has a very important role for the planned reduction of the deficit over the next three years.

The formation of the new government was worth a drop of 100bp in the Btp-Bund spread, from 250 bp on average during the 5S-Lega tenure to roughly 150bp currently. The drop in the actual cost of debt faced by the Italian Treasury has been even more dramatic: Italy now pays 0.8% for issuing 10y bonds, compared to the average 2.7% paid during the past government experience.

Lower interest costs help free 0.3% of GDP in the deficit, roughly 5bn. If sustained, the gain can be more substantial, as the Treasury refinances a growing share of public debt. If current interest rates were to prevail until 2022, the cumulative gain could be worth 40bn, or 2% of GDP.

The calculation, again, suggests that the budget could have been more ambitious in terms of fiscal consolidation. Absent the interest savings, the 2020 deficit would have been 2.5%, higher than the 2.4% originally proposed by 5S-Lega in late 2018 (with 2020 growth expected only 0.2% lower than in 2018).

Short-term gain, long-term pain

The 2020 budget does not seem to take a long-term view and dealing with structural issues is again postponed in favour of quick fixes for the next fiscal year. Part of this short-termism certainly has to do with the rushed way this government came into existence. But we believe that the changed underlying political conditions would have allowed, for example, a discussion on the fate of League’s flagship measures – the pension reform (Quota 100) and the flat tax.

The scrapping of Quota 100 would have freed 0.3% of GDP with certainty – thus making the budget much less dependent on the risky outcomes of fighting tax evasion. Moreover, the gain would have been permanent as carried over next fiscal years. The document contains no mention of that, suggesting that this option did not go past the political hurdles. There is also no mention of the fate of the planned initial flat tax phase in (worth about 0.1% of GDP in 2020). If the promised cut of the tax wedge is intended as the starting point of a comprehensive reform of the taxation system, then leaving the flat tax in place (limited to a narrow pool of beneficiaries) would make little sense.

Moreover, the budget keeps the government on a very narrow path against EU fiscal rules. Italy’s Medium Term Objective (MTO) is still a structural surplus of 0.5% of GDP. The speed of adjustment towards the MTO varies, based on economic cyclical conditions and potentially on flexibility clauses. Based on 2020 growth forecasts, the EU requires Italy to implement a structural adjustment of 0.5% of GDP in 2020. Assuming the government obtains the 0.2% flexibility it plans to ask, the required structural adjustment drops to 0.3 %. Against this requirement, the structural balance is instead expected to deteriorate by 0.1% of GDP in 2020 – falling 0.4 points short of the required.

The government would therefore be threading very close to a structural shortfall of 0.5% of GDP, which constitutes a “significant deviation” in the Stability and Growth Pact context. While these parameters have often not been respected, running close to a deviation means higher risks of future clash to Brussels, shall the political address of the government change.

Debt dynamics also remain optimistic. The updated budget assumes nominal growth rate higher than the implicit interest rate on the outstanding debt stock, starting in 2021. At 2.7%, that nominal growth forecast may prove overly optimistic – and lower outcomes would increase the primary surplus needed to stabilize the debt to GDP ratio following 2022 (especially as low current interest rates affect forecasts).

A missed Opportunity?

As it has often been the case in the past, most of the adjustment is delayed to the future. In fact, the 2020 budget projects the deficit to tighten to 1.4% in 2022. However, as time goes by, macro conditions may become less favourable for an adjustment.

Exceptional interest rate conditions are unlikely to persist. European rates continue to be depressed by low growth and ECB policies. As a result, the cost of Italian debt has never been so low. A reversal in European growth can easily start imposing upward pressure on interest rates. The government lost the opportunity of a more meaningful adjustment at the beginning of its term. As time goes by and elections approach, fiscal adjustments become less politically viable, and chances of a majority breakdown and the consequent pick-up in spreads increase too.

The structure of the budget partially reflects a rushed drafting, given the political volatility in summer. Still, some of the measures that didn’t go through (eg scrapping of Quota 100 or the flat tax) would have been politically affordable. In this respect, the 2020 budget law represents at least partially a missed opportunity. While this budget is probably conservative enough for the government to win the approval of the European Commission, it also lacks clarity as to what the strategy is to unlock much-needed growth.

Silvia MERLER– Head of Research, Algebris Policy & Research Forum

Gabriele FOA’, contributing author – Portfolio Manager, Algebris Macro Credit Fund

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