Italy Tax Increases Backfire as Monti Tightens Belts

Italian Prime Minister Mario Monti is facing signs that tax increases are beginning to backfire as his new levy on real estate goes into effect.

Value-added tax receipts have declined since Monti’s predecessor, Silvio Berlusconi, raised the rate by 1 percentage point in September as the economy was slipping into recession, government data released June 5 showed. The amount collected fell in the 12 months ended April 30 to the lowest since 2006.

Finding the right deficit-reduction mix as Monti fights to meet budget targets is critical for Italy to avoid becoming the biggest victim yet of Europe’s financial crisis. A slump that is driving up welfare spending is adding urgency to Monti’s effort to make the economy more competitive amid a growing backlash across Europe against austerity.

“This government has raised taxes too much,” said Alberto Alesina, a professor of political economy at Harvard University. “It would be much, much better to lower spending.”

Monti testifies in Parliament today for the first time since Spain received a bailout for its banks, leaving Italy exposed as the next potential investor target. Italy is unlikely to need a bailout because its finances are in better shape than Spain’s, Fitch Ratings Managing Director Ed Parker said yesterday.

The decline in VAT revenue figures may bolster the government’s efforts to postpone a further increase in the rate after October by 2 percentage points to 23 percent. That would put Italy on par with Greece.

‘Strong Deterioration’

Monti planned to tap more than 4 billion euros of projected savings from a government spending review to put off the VAT increase, which his deputies acknowledge may deepen the recession.

The economy shows signs of strong deterioration,” Finance Undersecretary Gianfranco Polillo told the Senate in Rome on June 6. “In light of the fall in domestic demand, betting on a further VAT increase would be incomprehensible and even wrong.”

Still, efforts to delay the increase may have been upended by deadly earthquakes in northern Italy last month that caused billions of euros of damage, as quake relief will also come from the spending review funds.

The $1.4 trillion Italian economy contracted 0.8 percent in the first quarter after slipping 0.7 percent in the last three months of 2011. Italy’s gross domestic product, the third- biggest among euro nations, will fall 1.4 percent this year, the European Commission estimates. That would be the deepest slide after Greece, Portugal and Spain among the 17 euro members.

Fostering Growth

Monti has advocated shifting to more growth-oriented policies and gained a potential ally with the May election of French President Francois Hollande, who defeated incumbent Nicolas Sarkozy by campaigning against austerity.

Monti’s tax increases were forecast to bring Italy’s budget deficit within the European Union limit of 3 percent of GDP this year even with expectations of a 1.3 percent increase in public spending. The measures were praised by Bank of Italy Governor Ignazio Visco, who in October succeeded European Central Bank President Mario Draghi, as an emergency stopgap that must be revisited and balanced with reduced expenses.

“This burden can be sustained only temporarily,” Visco said in a June 9 speech. “A stronger and more incisive fight against tax evasion and the implementation of spending cuts are the indispensable premises for the necessary reduction of tax rates.”

Tax Burden

Under Monti, Italy’s tax burden, the ratio of tax revenue to economic output, will rise to 45.1 percent this year from 42.5 percent in 2011, and won’t start falling until 2015.

Monti, a former university president and Goldman Sachs Group Inc. (GS) adviser, was brought to power in November to rein in bond yields and bring down debt. His 20 billion-euro austerity package raised retirement ages and was followed by measures to ease firing rules and promote competition. Increased rates on gasoline were enacted in December and on luxury goods earlier this year, while the first property tax payments are due next week.

“I don’t want to deny that we could have done more and better,” Monti said in a June 7 speech. Still, his reforms have produced results, he said.

Dodging Tax

The government had 99.8 billion euros in VAT receipts in the 12 months ended April 30 tied to internal trade, or transactions among domestic counterparties. That compares with 100 billion euro in the 12 months ended March 31 and 101.3 billion euros in the period ended April 30, 2011.

“VAT revenue does depend on growth in domestic consumption,” said Ian Roxan, director of the Tax Programme at London School of Economics and Political Science. “It is also not immune to evasion. It is certainly possible that in a time of austerity people become less willing to pay VAT.”

Italy loses more than 120 billion euros in unpaid taxes every year, according to the Equitalia tax-collection agency. The country retrieved 12.7 billion euros from the fight against evasion in 2011, up 15.5 percent from 2010.

Bond yields, which declined in the first three months of the year as Monti enacted his program, have surged since March as concerns about Spain’s finances and Greece’s future in the euro mounted. The yield on the country’s 10-year bond ended at 6.17 percent, the highest since January, and 4.7 percentage points more than that of Germany.

Above Average

The September increase in the VAT rate pushed Italy to 21 percent, which is 1 percentage point more the average among the 17 countries using the euro, according to a report last month from Eurostat, the statistics department of the European Union. VAT rates are as high as 18 percent in Spain, 19 percent in Germany and 19.6 percent in France.

Monti is showing signs of backing away from rigor even as Italians brace for the property tax, which reinstates levies on first homes. He pushed back Berlusconi’s timetable for a balanced budget by one year to 2014, and is actively trying to avoid a new VAT increase.

Total tax revenue fell 0.1 percent to 413.3 billion euros in the 12 months ended April 30, compared with 413.7 billion euros in the period ended on the same date a year earlier. Direct tax receipts, which include levies on personal and company income, fell 0.9 percent to 218.7 billion.

Total spending, including regional and local outlays, is set to rise in 2012 to 809 billion euros, or about 51 percent of GDP, according to Finance Ministry forecasts published in April. Central government spending is expected to decline by 0.4 percent as Monti cuts transfers to Italy’s regions.

The government must “reduce public expenditures drastically and quickly,” said Angelo Cremonese, an economics professor with specialization in taxes at Luiss University. “You don’t increase revenue by raising” tax rates, he said.

To contact the reporter on this story: Andrew Frye in Rome at afrye@bloomberg.net

To contact the editor responsible for this story: James Hertling at jertling@bloomberg.net

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