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Is Italy on a Collision Course With Europe?

Domes of San Carlo al Corso Church and St. Peter's Basilica
Sylvain Sonnet | Photographer's Choice RF | Getty Images
Domes of San Carlo al Corso Church and St. Peter's Basilica

Italy's fragile coalition government announced a raft of measures to boost its economy this weekend, but the package was conspicuous for the absence of spending cuts. The lack of measures could make it hard for the country to meet its deficit target and could put it on the path to conflict with Europe.

On Saturday night, Italy's Prime Minister Enrico Letta announced a package of 80 measures designed, he said, to boost the economy.

The measures included 3 billion euros worth of funding for public works projects this year and cutting bureaucracy. But the government seemed to be rowing back on spending cuts and tax increases imposed by the previous technocratic government with measures including plans to abolish a tax on yachts under 14 meters and plans to decrease the powers of Italy's tax collection agency, Equitalia.

"These are all measures that are needed to restart the country's economy," Letta said after a cabinet meeting that lasted more than five hours. Before the announcement Letta had assured the president of the European Commission José Manuel Barroso that Italy would keep to its target of a 2.9 percent budget deficit this year.

(Read More: Is Italy's Economy Minister Draghi's Man in Rome?)

Letta said the government would meet again this week to introduce further measures to simplify bureaucracy, loosen hiring rules and fight youth unemployment.

Under Pressure

The measures follow repeated calls from the country's leader for Europe to forget austerity and could increase concerns that Italy is diverging from a course of budgetary discipline.

Italy's Economy Minister Fabrizio Saccomanni announced last week that although a deeper-than-expected recession was hurting public finances, Italy could keep the budget deficit below 3 percent of output without more fiscal tightening. Furthermore, he told the Italian Senate last Thursday that the government would wait until after the German election in September before updating its economic targets.

(Read More: Euro Zone Faces Make-or-Break Summer)

Saccomanni is also under pressure from the coalition government's center-right partners, led by former prime minister Silvio Berlusconi, to cut unpopular tax increases implemented by Mario Monti's technocrat government.

He said that scrapping a controversial housing tax and a planned VAT (sales tax) increase – both demanded by Berlusconi - "would require severe measures to compensate the shortfall and these cannot be found at the moment."

In an interview with La Reppublica newspaper on Monday, the country's minister for Economic Development, Flavio Zanonato, said that he couldn't see a way to prevent a rise in VAT tax.

(Read More: 'Uneasy Calm' in Euro Zone Bonds Could Be Over)

"I'm used to telling the truth and I think Italians want to hear the truth. It's not that I don't want to block a VAT increase, I'm saying that it's very hard to find other means to [increase government revenue] in a short time. Saccomanni is charged with raising the tax and I hope that he manages it. The ball is in his hands, let's hope for a miracle," Zanonato said.

The tension within the coalition over taxes has not been lost on economists. Tobias Blattner and Emily Nicol from Daiwa Capital Markets said in a note on Friday that the "situation in Italy remains tense."

"With the need for unpopular tax increases potentially heightening tension among the coalition parties, while a failure to rein in the fiscal deficit would lead to a clash with the European Central Bank and the European Commission," they wrote.

"The latter last month agreed to end the country's excessive deficit procedure, demanding that the government keeps its deficit below 3 percent of GDP this year. But with the economy likely to contract at a much faster pace this year than the 1.3 percent the government predicts - we expect a contraction of 2.0 percent - the deficit is very likely to breach the 3 percent ceiling, pushing debt to above 132 percent of GDP," the economists said.

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