Commentary: Can You Say "Supply Side" In Italian?

Berlusconi's plan to cut income taxes could wind up causing a deficit nightmare

Is Italy ready for Reaganomics? Prime Minister Silvio Berlusconi thinks so. He is determined to push through one of Western Europe's most sweeping income tax cuts in decades. The proposal, announced on Mar. 28, would put an estimated $15 billion more a year in the wallets of Italians. Berlusconi maintains, as Ronald Reagan did, that the plan -- along with spending cuts -- will boost growth so much that tax revenue actually will increase in the long run.

The proposal would slash the top marginal tax rate from 45% to 33% -- lower than Britain's 40%, the chief legacy of former Prime Minister Margaret Thatcher. It would also chop the number of tax brackets from five to two: 33% for upper-income taxpayers and 23% for those earning $12,000 to $120,000 annually. The government says the tax cuts are needed to spur a stagnant economy. "If we don't cut taxes and put some money back in the pockets of Italians, consumption won't take off," says Economy & Finance Minister Giulio Tremonti.

There's no question that Italy, Europe's fourth-largest economy, needs some stimulation. It has been sputtering for a decade, with a scant 1% growth expected this year -- well under the 1.6% forecast for the European Union as a whole. But Italy's inability to rein in government spending bodes ill for the tax plan. Unless Berlusconi couples the tax cuts with serious reductions in government spending, the plan may trigger more economic woes than it cures. Most economists expect that Italy will breach the European Union's 3% budget deficit ceiling this year -- before any tax cuts -- joining the delinquent camp of Germany and France.

Tremonti insists that government spending will be trimmed to fund the tax reform, and he vows not to increase the deficit. But during the past three years, Berlusconi's center-right government has resisted government spending cuts, relying on one-time items such as tax amnesties to bolster revenues. "In 2003, amnesties were vital [to the budget], providing 1.5% of gross domestic product. But you can't repeat an amnesty every year," says Francesco Gia-vazzi, professor of economics at Bocconi University in Milan. In real terms, government spending rose 5.7 percent last year, twice as fast as the rate of inflation.

Undaunted, Berlusconi has greenlighted some $58 billion in spending on infrastructure projects over the next 10 years, including a $5.5 billion two-mile-long bridge that would connect the Italian boot to Sicily over the Messina straits. Economists agree that Italy needs infrastructure spending, especially to modernize highway and rail networks, but say such projects require cuts elsewhere. "Italy's in a very tough spot," says Daniel Gros, director of the Center for European Policy Studies in Brussels. "If there are no spending cuts, the deficit will explode."

A runaway Italian deficit is the nightmare scenario many European leaders conjured up when the country became a founding member of the European Monetary Union in 1999. Italy already labors under a national debt that is over 106% of GDP -- double the level of countries like France and Germany, and the highest in Europe. If Berlusconi goes ahead and cuts taxes without credible spending cuts, credit-rating agencies are sure to lower Italy's debt rating, raising the cost of borrowing

Berlusconi has promised voters that if he fails to win the tax cut, he will not run for reelection in 2006. With support for his government eroding and local elections approaching in June, many are betting that the Prime Minister will ram some version of tax cuts through. That will set the stage for a battle over Italy's fiscal future. But if the government fails to keep a lid on spending, Berlusconi's bid for a supply-side kick to growth is sure to backfire. And the rebuke could be his undoing.

By Gail Edmondson

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