Conte’s Team Crunches Budget Numbers in Bid to Avert EU Clash

(Bloomberg) -- Italy’s 2020 budget is still in a state of flux, but one thing appears certain: there won’t be a repeat of last year’s bruising battle with the European Union.

While Rome and Brussels are some distance apart at the start of the financial planning process and plenty of back-and-forth is to be expected, this time both sides appear eager to compromise.

A more collaborative approach will likely mean that EU rules are broadly respected while still allowing the Italian government to claim that it’s kept its promises for new “expansionary” measures to kick-start the economy.

Finance Minister Roberto Gualtieri is facing daunting challenges as he puts together next year’s spending plans: stagnant growth amid a worldwide slowdown, huge and rising debt, and a fragile ruling coalition in desperate need of a political win.

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“The alliance will be especially tried when it has to make the numbers for next year’s budget add up. (...) The debate ahead of the budget submission to Brussels in mid-October will be contentious and neither coalition partner will want to be seen as the instigator of more austerity.”

--David Powell, senior euro-area economist

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Further complicating matters: an automatic sales tax hike, slated for January, that the government wants to avoid at all costs.

Gualtieri is due to present an outlook on Italy’s public finances in the coming days, ahead of an Oct. 15 deadline for submitting the draft budget to Brussels. Final approval by the Italian parliament must come by year end.

The budget is the first real test for the more pro-European direction of Prime Minister Giuseppe Conte’s new coalition, after his previous government went toe-to-toe with the EU on everything from migration to economic policy.

While Conte was able to claim an early success Monday, when European interior ministers took initial steps toward a migration deal, the stakes are higher on the budget.

Here’s a rundown of the major issues, and a look at what we know and don’t know so far.

Deficit

If there’s one key number policy makers and markets will focus on, it’s this one. Italy’s deficit was 2.2% of gross domestic product in 2018 and will likely be around 2.1% this year, broadly in line with the 2.04% the country committed to last December.

For 2020, the deficit target could be set as low as 2%, according to a senior official. That may be enough to allow everyone to say that Italy is respecting an EU recommendation that it cut spending by 0.1%.

Structural Deficit

The EU itself focuses more tightly on this measure to assess compliance with budget rules. While Italy is required to reduce its structural deficit -- which discounts one-time measures and effects -- by 0.6 percentage point, it can count on some flexibility here. For example, extra spending can be permitted in the wake of natural disasters.

Even a reduction of 0.1 percentage point might be enough to allow Italy to be considered compliant.

It will be up to Italy’s politicians to decide how much wiggle room to push for. While an all-out conflict with Brussels is unlikely, the new government will have to decide whether to hold on to some of its political capital or spend it all now.

Early indications are that Italy may want to play the flexibility card right away: daily Il Messaggero reported Tuesday that the government could opt to exploit Brussels’s expected leniency and raise the deficit to 2.6%.

Debt

This is the elephant in the room. Italy has repeatedly failed to bring down its massive debt and most likely won’t do so next year either. Adding complexity: a recent Bank of Italy recalculation which brought the 2018 debt to almost 135% of GDP.

Under EU rules, the requirement that Italy must lower its debt can only be waived in case of an outright recession. And for all the market lull now, ratings agencies are keeping a close eye on the trajectory of the country’s debt.

Yields

Even if Italy’s debt is growing, the cost of that debt is falling. Yields fell heavily over the summer, mostly on the back of the promise of renewed stimulus from the European Central Bank. The return on Italy’s 10-year bonds fell from 3.7% last October to 0.84% this month.

This alone means savings of 6.2 billion euros ($6.8 billion) in 2020, according to economist Lorenzo Codogno.

Growth

Italy’s populist government based last year’s spending plans on unrealistic growth assumptions. Gualtieri appears to be taking a more prudent approach.

The government forecasts 0.2% growth in 2020, according to the senior official. Rome also expects that its budget measures will add 0.2 or 0.3 percentage point to that trend. That would lead to growth of 0.4% to 0.5% -- slow, but still a distinct improvement from the near stagnation of 2019.

VAT Increase

Both parties in the ruling coalition agree that avoiding an automatic hike in VAT is a top priority. But that means finding additional revenue of 23 billion euros, or 1.3% of GDP, either through spending cuts or new taxes. And that will eat up a lot of the resources available for the government’s other plans.

Some of the money could come from lower-than-expected spending from the previous government’s flagship measures -- early retirement and an income support tool.

Tax Cuts

Forget about the 50 billion-euro tax cut promised by League leader Matteo Salvini: his party’s out of the government now. But some cuts could still happen.

Government officials have talked about reducing tariffs on labor by about 5 billion euros and of ending preschool fees for low-income families. But if avoiding a VAT hike is the main priority, there’s little scope for large-scale fiscal stimulus.

One option being discussed: retooling Italy’s vast array of subsidies -- especially the more than 19 billion euros that have a damaging effect on the environment. But reducing tax breaks on truck diesel fuel, for example, could spark a political war. Expect baby steps at best.

--With assistance from John Follain, Viktoria Dendrinou, Giovanni Salzano and Marco Bertacche.

To contact the reporter on this story: Alessandro Speciale in Rome at aspeciale@bloomberg.net

To contact the editors responsible for this story: Chad Thomas at cthomas16@bloomberg.net, Jerrold Colten, Zoe Schneeweiss

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