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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 
 
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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. 
 
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BUDGET/GROWTH ASSUMPTIONS TOO OPTIMISTIC 
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¶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 
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THE FACTS 
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¶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. 
 
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FOREIGN ASSISTANCE 
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¶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 
 
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DEFENSE 
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¶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. 
 
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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. 
 
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PRIVATIZATION 
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¶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. 
 
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COMMENT 
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¶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