VAT and the "white knight"
The real economy is flagging, even though interest rate savings have been extended: to block the VAT increase a rabbit needs to pulled out of a hat somehow…
- Thursday, 12 September 2019
It was a very tall order and the likelihood of success was slight. So they just gave up. If one views the timing of the governmental crisis with an eye on the economy, Italian politics makes much more sense. If Salvini hadn't tried to force the issue, the summer promises would have come to a head in autumn. The publication of the state's financial goals to be drafted by the middle of September were supposed to mark the start of the institutional and political process required to design the financial budget for 2020 to be readied by December. But the second party in government – leading in the polls – has shirked the process: someone else will have to pick up the slack, or the next elections would decide who would draft it. The solution to the puzzle will depend on Mattarella's institutional awareness and the moves made by the parties. But seeing as the urgent need for a budget will be one of the main issues, or pretexts, on the table, it's worth assessing the situation that the defunct League-5SM majority has left behind, and possible alternative scenarios.
On a purely economic footing, the budget planning session to take place at a time of crisis has to come to terms with a few negative and other positive developments: on the one hand, the worsening of the real economy; on the other, a kind of posthumous 'gift' by Mario Draghi, that means savings in terms of interest expenditure; and positive throwbacks from the half-year budget adjustment made in July. Two very useful but not decisive elements, when faced with the mountain that has to be climbed in 2020: starting with the need to fund a 27.6 billion mortgage, a sum which needed doubling if Salvini and Di Maio's promises were to be fulfilled.
One thing is for sure: the "white knight", the unexpected saviour, will not come in the form of an economic revival. For 2020 the most reliable forecasts expect GDP growth to hover around 0.7 – 0.8%. Nothing to cheer about. The economic downturn has a two-fold negative impact on public accounts: it has a bearing on tax and social security revenue and it makes it harder to meet the European deficit-GDP parameters. Although both the League and the 5SM have claimed they will ignore these parameters, so far, during all negotiations with Brussels, Rome has ended up complying with its Eurozone membership obligations. They did so for the 2019 budget, and then with the budget adjustment of 1 July. And that's what they meant to do in autumn, probably, either sooner (with a budget in line with the previous EU Commission indications) or later (by penning a higher deficit and then engaging in negotiations with the new EU Commission) if things hadn't come to a head. For the time being, the numbers written and approved by Brussels refer to a deficit tendency, for 2020, of 2.1% of GDP.
The problem is that this 2 - 2.1% includes a rise in VAT, meaning the safeguard clauses that drag on from year to year. But everyone wants the VAT increases to be ruled out: this means the government, for 2020, has to find 23.1 billion right off to avoid raising VAT. Another 3 – 4 billion are also needed to refinance a number of expenditures. So the amount already stands at close to 27.6 billion. To which one has to add another 5 if the deficit is to be kept at 1.8% of GDP as agreed with Brussels.
Conversely, what possible savings on expenditure can be made, given this initial burden? According to the Parliament's Budget Office, three quarters of the July budget adjustment for 2019 will carry over into 2020. This essentially concerns the lower expenditure for early retirement plans (quota 100) and citizen income: 3 billion, partly due to the government's overestimation of the "approval" of these same provisions. Another 2 billion, unless markets play up unexpectedly, are savings related to lower interest payments due the expansive monetary policies adopted by the ECB and the lowering of the spread – until the August turmoil kicked in. With five billion of "aid" and almost 28 "mortgaged", the starting line for the budget was always a steep one.
A situation made even more challenging by the intentions voiced for 2020 by both the League and the 5 Star Movement: the former was still hoping yo extend the flat tax further, in line with its electoral campaign promises: a single 15% tax rate on all incomes. The 5 Star Movement had two favourite issues: taxes, where it means to lower the tax brackets for the middle classes, and a minimum wage.
These fanciful proposals to be included in the budget are likely to pop back up during the electoral campaign, whenever it takes place. And seeing as the proposed minimum wage,
despite not having a direct impact on public spending, is likely to face challenges, given the political and social conditions – the competition between the two former allies will once again revolve around taxes and the different proposals on the table.
It has to be said that none of these is a true "flat tax". Initially the League called for the application of a single tax rate of 15% - which currently only applies to freelancers within an certain income range – on all family incomes below 50,000 euro. This proposal has many technical hitches, starting with the fact that some taxpayers would still be taxed on an individual basis, while others would move over to a "family" income tax. And the flat tax, by its very nature, is more advantageous for higher incomes. In its original formulation, it would cost around 17 billion euro. Where to find them? There's talk of a radical overhaul of current deductions, starting with fixed and health deductions, but this would end up being a zero-sum game for many taxpayers, who would gain from the tax cut what they lost in deductions. Partly in order to confront this problem, the new "flat tax" proposal is much less sweeping, and limited to income increases: essentially, the tax cut would only benefit those who earned more in 2019 compared to the previous year. A complicated system and a source of unfairness that would be hard to justify.
The 5SM proposal on the other hand envisages three tax rates – 23%, 37% and 42% - and a "no tax area" of 10,000 euro for everyone. To understand what this would cost, and therefore find appropriate funding one would have to know whether the "Renzi bonus" still applies aply. The Five Stars want to lower taxes for the have nots, and would therefore be loath to cut a bonus that was designed specifically for the middle to lower classes: then the entire cost of the plan would be around 23 billion.
So with either approach to tax cuts, the new provisions for 2020 and funding of the safeguard clauses to avoid raising VAT would mean a budget outlay of at least 40 billion, which no one knows where to find. Unless one looks among the files published by minister Giovanni Tria who has often explained, scientifically, why he prefers to tax consumption instead of labour. This means he could be in favour of a compromise that increases VAT – though less than previously suggested – while introducing a number of cuts to taxes and/or insurance payments on earned income. But only to a limited extent and in gradual steps, given the external constraints. This was the picture facing the government before Salvini's desire to exploit his improved poll showings (which, once the details of the budget were announced, might have waned) upset the applecart. Whoever picks up the pieces will still have to deal with the VAT increase: a situation that has political as well as financial implications, seeing as many MPs want to defer elections in order to avoid the VAT increase. But seeing as this problem has been under consideration, or should have been, for months, its very likely that both Tria's financial experts and those of the opposition have already come up with a proposal that could be approved right away. If this is not the case, the VAT increase, instead of acting as a safeguard clause for public accounts could become a survival clause for the current parliament and add legitimacy to new majorities and potential "technical" governments.
This article is also published in the September/October issue of eastwest.