Italy: As Exports Evaporate, So May Tax Cuts

After outpacing euro-zone growth in the fourth and first quarters by a percentage point, Italy is now joining Europe's slowdown parade. Moreover, a softer economy complicates the efforts of Prime Minister Silvio Berlusconi's new center-right government to deliver its promised tax cuts, since Rome's finances are deteriorating.

Berlusconi's victory and clear majority in Parliament has buoyed business and consumer confidence. Consumers are especially upbeat. The government's pledged tax cuts would come on top of cuts by the previous government. Hefty pay awards for school teachers and civil servants will keep consumers spending. Plus, lower energy prices are pushing down inflation, which is lifting purchasing power.

However, gains in domestic demand cannot offset the impact of the global slowdown on Italy's export-intensive economy. Second-quarter economic growth ground to a halt. In May both industrial production and new orders were disappointing, and their second-quarter levels are far below their first-quarter averages, suggesting that manufacturing is in a recession.

New economic weakness and past fiscal largesse mean that the public deficit will total at least 1.6% of gross domestic product this year, twice the 2001 target of 0.8% specified in the euro zone's Stability Pact.

In addition, the government's five-year economic plan for 2002-06, released on July 19, is long on ambition and short on details. It forecasts economic growth of 3.1% in each of the next five years, a feat Italy has never achieved. It also projects a balanced budget by 2003, which private economists say is impossible.

For the second half, Berlusconi's plans will focus on the goals outlined in his "first 100 days" package, including investment incentives, further labor-market deregulation, and efforts to reduce the underground economy. However, Berlusconi will be hard-pressed to show the euro zone budgetary discipline without delaying a sizable portion of his planned new tax cuts.

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