There Is Good And Bad Austerity, And Italy Chose Bad

Italians understood the gravity of their economic situation in November 2011 when Mario Monti was appointed, and were prepared to make sacrifices to help pull their country back from a cliff. The political leadership wasted the opportunity, choosing the easier path of higher taxes, and has paid the price at the polls, with a partial defeat.

Italy’s election outcome is not, as the critics claim, the resounding death knell of austerity economics in Europe.  Nor does it spell the end of it in Italy.  There is “austerity” and there is austerity. “Austerity” implemented through tax hikes is harmful, but austerity based on appropriate spending cuts is the best way to reduce a country’s public debt burden. Implementing pro-growth reforms as part of the fiscal adjustment process can minimize any economic cost that budget cuts may have. This is especially important in the case of highly regulated economies where the government spends about half of its GDP, as is the case with Italy. 

While history will apportion the blame for the sad state of Italy’s economy between Mario Monti, his coalition partners, the opposition, and various interest groups, one thing is certain: the Italian government implemented the wrong kind of austerity.

First, it raised the tax burden on its workers.  Tax revenues consumed an additional 2.5 percent of GDP, bringing the total up to 45 percent.  While some of those increases were already in place when Monti took office in November 2011, he chose to continue with the tax hikes.  Considering the large amount of tax evasion in Italy (estimated conservatively at around 15 per cent of GDP) those who actually pay their taxes are truly squeezed.

Second, with the exception of good pension reform, the effect of which will not be felt on the budget for a few years, the actual spending cuts have been minuscule. Traditionally, the “cuts” in the budget presented in parliament are mostly a reduction in transfers from the central government to local governments. But the latter often reacts by raising local taxes, effectively wiping out the good from “spending cuts.”  The only real cuts approved by the Monti government in 2012 were tiny; somewhere between 1 billion and 8 billion euros, representing at best, less than 1 percent of the $790 billion budget. These are a tiny fraction of Italy’s GDP, plus it remains uncertain whether or not they’ll be fully implemented to begin with.

This is unfortunate when we consider a 2012 report by a government appointed commission that suggested a better path: major cuts to corporate subsidies and elimination of “tax expenditures” in exchange for generalized reduction of taxation on labor costs for firms. However, the suggestions were ignored, possibly, but not exclusively, for lack of time. One result of ignoring these recommendations is increasing unit labor costs in Italy, while they are falling in countries like Spain and Greece. This, in turn, makes it more expensive for firms to hire workers, and exacerbates already high unemployment.

Even worse, the Monti government was unable to aggressively attack what has become the most odious form of government spending in Italy:  the pure waste taking place among elected officials locally and nationally; the latter rationalized as “the cost of doing politics.” Under the pretense of austerity, Italians were asked to pay more taxes while observing inept politicians enjoy their luxurious life style. As the former comedian Beppe Grillo’s remarkable showing suggests, Italians are infuriated at the government’s mismanagement of public finances, the corruption, and the unhealthy marriage between lawmakers and big businesses.

The bottom line is that if the Italian economy is suffering, it’s not because of “savage” spending cuts.  In fact, when it comes to actual spending cuts in Italy, “there’s no there there.” The sad reality is that tiny spending cuts have been overwhelmed by tax increases. In truth, the Italian experience is consistent with the findings of a growing body of academic literature on the issue: fiscal adjustment dominated by tax increases typically is a recipe for failure: It fails to stabilize the debt and it is more likely to cause economic contractions. Sure enough, Italy’s economy shrank by 2.2 percent in 2012, and most forecasts suggest it will not return to positive growth in 2013.

By contrast, spending-based fiscal adjustments accompanied by supply-side reforms can sometimes have a positive impact on economic growth. Very unfortunately for Italy’s citizens, Monti went the wrong way in his pursuit of austerity: he raised taxes rather than cut spending, and then his supply side reforms were timid at best.

Italy’s reward for Monti’s inept policies is mounting debt, a slow economy, and a resuscitated Silvio Berlusconi. Good luck with that!