Italy’s Populist Government May Not Bring Doom

(Bloomberg Opinion) -- The economic policy proposals of Italy’s populist coalition have spooked the markets, which have driven up government debt yields. And yet the two coalition partners, League and the Five Star Movement, may be on to something with a proposal for a two-tier flat tax.

Today, Italy has five income tax brackets with rates ranging from 23 percent to 43 percent. The coalition proposes to “flatten” them to two, with rates of 15 percent and 20 percent. On paper, the change threatens the government with a big revenue loss. Yet, if the experience of Russia and Eastern European countries is anything to go by, Italy could end up collecting more taxes, despite the obstacle of the country’s long history of spotty compliance and enforcement.

Italy has a major problem with tax evasion. According to a recent paper written by Andrea Albarea and collaborators for the Italian Senate’s Impact Assessment Office, Italians underreport employment income by 3.5 percent, self-employment income by 39 percent and rental income by 65 percent. The total “tax gap” is between 16.5 billion euros ($19.5 billion) and 38.6 billion euros a year. Italy has a shadow economy that’s bigger than the European average — up to 19.8 percent of economic output, compared with 10.4 percent in Germany and 9.4 percent in the U.K., according to the International Monetary Fund.

Russia’s 2001 tax reform, which scrapped an ill-considered progressive income tax system from the early 1990s for a 13 percent flat rate, increased receipts. In 2002, the year after the introduction of the flat tax, the economy grew 5 percent in real terms, but income tax receipts increased by more than 25 percent.

More than 20 countries followed Russia with similar changes, and though some recent studies have challenged the efficiency of these programs, flat taxes have generally delivered. For example, Bulgaria, which introduced an ultra-low flat income tax of 10 percent in 2008, halving the existing rate for the lowest bracket, saw receipts increase as a share of total government revenue. In 2009, the year after the flat tax was introduced, income tax receipts made up 10.2 percent of all tax revenue, compared with 9.4 percent in 2007. And Slovakia didn’t get a revenue increase when a leftist government abolished a flat tax and returned to a progressive system. 

The advantage of a low, flat tax is that people tend to pay it voluntarily because it’s easy to understand. Convoluted systems with multiple brackets and many deductions practically require taxpayers to get professional help, and few Italians who file a tax declaration can get by without a consultant. That’s a strong disincentive to declaring multiple types of income. Simpler income tax rules are also easier on small and medium-sized employers charged who must deduct income taxes for their workers’ paychecks.

Apart from increasing government revenue (or, in some places, having only a marginal impact on them), flat taxes in Eastern Europe have led to demonstrable welfare effects, which produced increases in consumption. In turn, that can boost government receipts from value-added taxes or sales levies. Italy isn't great at collecting consumption taxes: Its VAT gap, at 25.8 percent of what the government should receive, is at the higher end for the European Union. The country is undercollecting about 35 billion euros a year. The challenge for the populist government is to improve compliance and harness some of the consumption gains a flat tax might produce.

Populists elsewhere, notably in Hungary (which charges a 15 percent flat income tax) and Poland (with a much simpler system than Italy’s current one), have been remarkably successful in increasing the collection of consumption taxes. They have to take in more tax revenue because, like the new Italian coalition, they tend to make expensive social promises to get elected. These promises, like the current nationalist Polish government’s now-realized idea of big payouts to families to improve demographics, look unachievable at first. But funding them becomes a matter of political survival for the populists, and it motivates politicians to take tax collection seriously. 

Since Prime Minister Viktor Orban of Hungary came to power in 2010, the country’s budget deficit has dropped to 2 percent of gross domestic product from 4.5 percent. Poland’s deficit of 2.6 percent of GDP when the current nationalist government took over, was 1.7 percent, the post-Communist record low, last year.

Italian populists may turn out to be less reasonable or less skillful than their Eastern European counterparts. They certainly harbor greater social ambitions with their planned experiment of creating a basic income, introducing a minimum wage and lowering the retirement age. But there’s no reason, at least yet, to assume Italy will be unable to do some variation of what Poland and Hungary have done. 

The new coalition now needs to get out of election mode and only roll out spending programs that are funded by tax reforms and more effective collection. Joining the ranks of the EU’s maverick states doesn’t necessarily spell economic disaster, even if these reforms often are accompanied by unsavory political change, as in Poland and Hungary.

©2018 Bloomberg L.P.