Italy and the Populists: Heading for an Even Hotter September?
It may take a further rise in Italian bond yields to remind the populist government’s leaders in Rome that their room for maneuver to operate with more debt is very limited.
- It may take a further rise in Italian bond yields to remind the populist government's leaders in Rome that their room for maneuver to operate with more debt is very limited.
- The risks that Italy’s finance minister resigns, that the government falls apart or that a blatant breach of Italy’s fiscal commitments to the EU could trigger a bond market rout are not negligible.
- Within limits, the EU may accept the argument that Italy needs some additional fiscal space to cope with the impact of the migrant crisis.
- It may well take an occasional further rise in Italian bond yields to remind the novice political leaders in Rome that their fiscal space is very limited.
In Italy, serious budget discussions between Italy’s comparatively prudent finance minister Giovanni Tria and the populist government’s key political leaders have started. The divisive issues could come to a head in the next ten weeks as Italy prepares its draft budget for 2019.
The government wants to agree key fiscal parameters by September 30th, before it has to submit the budget draft to parliament and the European Commission on October 15th. In political terms, September could become a very hot month in Italy.
In their coalition agreement of June 1, 2018, Five Stars and Lega made four expensive promises:
• Dual rate income tax with two bands of 15% and 20%: this two-tier “flat” tax could lower tax revenues by €30bn (1.7% of GDP) in 2019 if applied to companies and large families (or even €50bn if implemented for everybody).
• Citizen’s Income of €780 per month: if applied to all, such a guaranteed minimum income could cost €17bn per year (1% of GDP).
• Pension reform reversal with potential costs of at least €5bn in 2019 (0.3% of GDP), and possibly significantly more.
• Cancelling the scheduled increase in the VAT from 22% to 24.2% in 2019: This would cause a loss in revenues of €12.5bn next year (0.7% of GDP).
Upon forming their coalition, 5Stars and Lega agreed to introduce the two most expensive promises, the two-tier flat tax and the minimum income, only in stages.
Lega leader Matteo Salvini has emphasised that the government has five years to implement its plans. 5Stars, for its part, want to pay the minimum income initially to those who actively search for a job.
A fiscal scenario for 2019
The political debate about Italy’s 2019 budget still seems to be in its early stages. Various ideas as to which promises should be kept to which extent are floating around in the press.
Although 5Stars and Lega both want to prevent the scheduled rise in the VAT, some reports suggest that Tria may allow the rise to go ahead but use a third of the proceeds to partly compensate the losers, possibly through lower petrol and other excise taxes.
It is too early to predict the outcome of the negotiations with any confidence. However, it is quite possible that, as a result of the contentious internal deliberations, Italy’s 2019 structural deficit would rise by almost 0.9 percentage points of GDP, lifting it to 2.6% of GDP from 1.7% this year.
Three potential problems
This scenario would raise three problems for Italy:
• First, it would weaken the position of finance minister Tria. He opposes an increase in the structural deficit. However, a 2.6% headline deficit in 2019 could still suffice to bring the debt ratio down slightly (abstracting from other factors, a deficit of 3.3% of GDP would keep the debt ratio constant at about 131% of GDP if nominal GDP rises by 2.5% or so). Tria may thus decide to remain in office.
• Second, it would fall foul of Italy’s constitutional requirement to run a balanced budget in normal times. Of course, that would not be new for Italy. On balance, we would not expect President Sergio Mattarella to trigger a political crisis by vetoing the budget (or challenge it at the constitutional court) as long as the projected headline deficit remains well below the 3% Maastricht benchmark.
• Third, it would ignore Italy’s commitment under the EU’s Stability and Growth Pact to reduce the structural deficit at a sufficient speed. Upon passing judgement on the medium-term fiscal plan of the Gentiloni government in May, Brussels had demanded that Italy bring down its structural deficit to 0.8% of GDP in 2019.
Noise now – more serious trouble later?
Brussels often lets countries get away with some fiscal overshoot. Italian fiscal plans roughly in line with the scenario presented above would severely test the patience of Brussels.
Within limits, the EU may accept the argument that Italy needs some additional fiscal space to cope with the impact of the migrant crisis. It is quite possible that the EU, upon evaluating Italy’s 2019 draft budget in late 2018, will raise objections and ask Italy to correct its plans over the coming six months.
Either way, the fiscal plans of the radical government in Rome present a grave risk to the country’s financial stability and the long-term sustainability of Italian debt. The discussions about the 2019 budget can bring these touchy issues to a head over the next ten weeks.
The risks that finance minister Tria may resign, that the government may fall apart as 5Stars and Lega fail to agree on their priorities or that a blatant breach of Italy’s fiscal commitments to the EU could trigger a bond market rout are not negligible.
It may well take an occasional further rise in Italian bond yields to remind the novice political leaders in Rome that their fiscal space is very limited.