Italy: Will Berlusconi's Tax Cuts Make A Mark?

After much government infighting, Prime Minister Silvio Berlusconi finally got an $8.7 billion tax-cut package passed. Most of the cuts will go to consumers. However, the money could be used more wisely.

On Nov. 26 the government agreed to a bill that cuts income taxes by $8 billion via adjustments to tax brackets. The hope is that the moves will improve consumer spending, which would boost overall economic growth. In September retail sales were down 1.4% from a year ago, and the November services and manufacturing purchasing managers' indexes fell to their lowest levels since September, 2003.

But economists believe the cuts will have little impact. "There is a real risk that, given the low level of consumer confidence and anxieties about the future, most of the tax cut will be saved for precautionary motives," says JPMorgan Chase economist Pasquale Diana. Plus, tax hikes on tobacco and other items will offset some of the cuts.

Italian Industry Is In A Slump
A key source of consumer concern is jobs. The weak labor market can be traced to the competitive position of Italy's business sector. Both the type of industries and the size of companies that dominate the economy are putting Italy at a competitive disadvantage compared with other countries. Low-tech items such as leather goods, food, and textiles account for a significant part of Italy's exports, but these sectors face growing competition from lower-cost producers abroad. The disadvantage is exacerbated by the rising euro.

In addition, the average size of an Italian manufacturer is among the smallest in the euro zone. Smaller businesses typically don't do as much research and development or capital investment as large companies, says Diana. With foreign investment pouring into countries such as China, Italy's smaller businesses risk falling behind even further.

The size of the new tax cuts is fairly small -- just 0.5% of gross domestic product. Even so, using the money to help fund R&D programs, boost investment, or help cover Italy's growing public pension obligations would better serve the economy in the long run.

By James Mehring in New York

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