Friday, October 01, 2010

Italian Economic Orthodoxy

-- Posted by Neil H. Buchanan (from Prato, Italy)

I have been in Italy for the past four days, attending a conference on globalization sponsored by Monash University, an Australian institution with a campus in Prato. I have not had an opportunity to see much of the country, but I did listen to a very interesting presentation by the sole Italian scholar in attendance at the conference. (The line-up: one Brit, one American, one Italian, one Canadian, one Malay, and 12 Aussies. I now know a lot more about Australian politics and policy than I did a week ago.) In his presentation, the Italian scholar described a policy that the national legislature adopted over the summer, in response to the ongoing recession. While the details were unfamiliar to me, it became increasingly clear as the discussion continued that this was simply a variation on the standard prescription of more tax cuts for businesses to solve all problems. It seems no more likely to succeed than similar policies adopted in the U.S. in 2001 and 2003.

The new policy works like this: A non-Italian company can, if it directly invests in Italy (that is, if it actually builds or hires an Italian facility and hires local workers, as opposed to simply buying Italian financial instruments), opt to be taxed as if its facilities were actually located back in its home country. Even better, from the standpoint of such a company, it can choose to be taxed under the rules of any EU country, not just its home country. This added twist removes one of the most intuitive explanations for a home-state tax rule, that is, the reduction in compliance costs for a company that would not have to learn Italian tax law by opting to operate under its familiar home-country tax regime. A German company can, instead, decide which EU country has the lowest taxes and tell the Italian government that it, for example, wishes to be taxed as if it were an Irish company.

This new policy, therefore, is simply a way of giving foreign companies a tax cut in exchange for their decision to locate new operations in Italy. It means that the Italian government does not need to write its own new tax laws that would apply to such foreign companies, but it has the similar effect of giving businesses a tax break. Lower taxes for business are presumably thought to encourage more investment in Italy, as an elixir to fight the economic slump. The policy is, moreover, only good for the next three years, making it even more obviously a measure designed to fight macroeconomic headwinds.

It is too early to know whether this policy will work, given that it is only a couple of months old. What is obvious, however, is that this is just a different kind of beggar-thy-neighbor policy. Rather than enacting trade restrictions designed to help the home country at the expense of other countries (who would presumably have an incentive to retaliate), this is simply tax competition aimed specifically at investment from foreign companies. Given the global slump, this is a zero-sum game, and the Italian government has now thrown its weight behind getting its part of a too-small pie, with a policy that will become less effective as others retaliate.

Even so, it is difficult to fault the Italian political establishment too severely for this choice. Italy's debt-to-GDP ratio is now 110%, making the usual cries against Keynesian fiscal policies even more shrill here. (Note, however, that being on the high side of 100% is not meaningful in and of itself, since the 100% point means nothing. That is, it is not like hitting some mathematical wall and then smashing through it. The difference between 99% or 101% really is just 2%, with no significance residing in the latter figure being in triple digits.) Even though the national unemployment rate is 8.5%, leaving plenty of slack in the economy, and even though there are plenty of public investment projects that those unemployed workers could be hired to build, the conventional wisdom here -- as in the U.S., the U.K., Germany, and basically everywhere else, it seems -- is that even short-term increases in deficit spending are simply out of the question.

What would happen if the Italian government did increase its deficit in the short term? Despite the formal limits of 3% annual deficits and 60% overall debt agreed to by all EU countries, nearly all such countries are currently in violation of those guidelines, for obvious reasons: Those limits were not written to be realistic during a deep recession. (In fact, the limits themselves are utterly arbitrary, without an economic theory to support the particular numbers that were chosen -- even in times of prosperity.) The Italian scholar making the presentation said that the talk is all about "not being like Greece," which had a big debt-related crisis earlier this year. It turned out, of course, that the Greek situation was misused to support the anti-debt conventional wisdom more broadly, since Greece was truly unique (in ways beyond the scope of the discussion here).

No matter the reasons, however, nation-based expansionary fiscal policies are evidently off the table. What choices remain? As Paul Krugman explained earlier this year with regard to the Greek situation, the choices are: domestic austerity (ride out the crisis while making it worse for your workers), expansionary monetary policy from the European Central Bank, help from more prosperous countries, or dropping the Euro and going back to a domestic currency. None of the first three were forthcoming for Greece, and there is no reason to think that anything would change for Italy. Breaking up the Euro zone would be a huge mess, and it is likely that doing so would be very painful for many countries, too.

That leaves the option of trying to entice foreign businesses to relocate. Having much less fiscal freedom than the U.S., and no monetary freedom, this is the bad choice that Italy is stuck with. If it helps Italy, it will hurt someone else. This is not a recipe to end the recession. It is just a plan to make it more painful for some other country's most vulnerable people.


michael a. livingston said...


It's good to see you're spending more time in Italy! My only warning: you have to consider Italy's, well, unusual tax culture before learning too many lessons from them. It's true that they don't have much room to raise taxes. But they have plenty of room to enforce the ones they already have on the books. With this PM, however, that seems somewhat unlikely.

aminos lahragui said...

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