Potential output and structural
reforms after the crisis:
the case of Italy
Andrea Gerali, Alessandro Notarpietro, Massimiliano Pisani
12° Macroeconomic Policy Research Workshop
Magyar Nemzety Bank, 19-20 September 2013
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Potential output and structural reforms after the crisis in Italy
Motivation
 Crisis: challenges for demand management, but it can
also affects supply-side (potential output)
 Euro area: high taxes on labor and capital, lack of
competition in services sectors (many countries)
 Public finance: fragile conditions might require
consolidation that may hamper capital accumulation and
reduce potential output
 Italy: large public debt, sovereign risk, poor performance
of supply-side
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Potential output and structural reforms after the crisis in Italy
Overview
 Assess effects of (1) competition-friendly and (2) fiscal
reforms on Italian potential output after the financial
crisis using a large-scale 3-country NK-DSGE model
 (1) markup reduction in services sector (10 p.p.)
 (2) permanent reduction in debt/GDP (10 p.p.)
 Study (1) and (2) both separately and together
 Role of sovereign risk and monetary policy (short-medium
term effects)
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Potential output and structural reforms after the crisis in Italy
Preview of results
 Fiscal consolidation increase potential output at the cost
of a recession
 Pro-competition reforms in services sector positively
affect potential output also indirectly, by allowing for
more aggressive tax cuts for given debt/GDP ratio
 The right policy mix seems to be to implement both at
the same time, as reforms compensate short-run costs
of fiscal consolidation
 Taking into account sovereign spread dynamics and the
role of MP during a crisis does not change the picture
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Potential output and structural reforms after the crisis in Italy
The IdEA model (Italy and the rest of the EA)
 3-country DSGE model: Italy (IT), rest of EA (REA), rest of
the world (RW)
 IT-REA: currency union, single monetary policy
 Consumption: final good, made of intermediate nontradables (NT) and tradables (T)
 Interpret NT as services
 Intermediate T and NT produced using K and L
 Monopolistic competition in intermediate sectors (and
labor)
 Nominal and real rigidities
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Potential output and structural reforms after the crisis in Italy
Model: fiscal block
 Fiscal policy at regional level, government budget constraint:
 Btg1
g
c
g

B

(1


)
P
C
 H
t 
t
N ,t
t  Trt  Tt
 Rt

 Italian fiscal rule:
fit
fit 1
1
2
 btg   btg 
 g   g 
 b   bt 1 
 fit (either tax rates, lump-sum transfers, public C) responds
to (i) distance of debt-to-GDP ratio from target and (ii) deficits
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Potential output and structural reforms after the crisis in Italy
Model: markups and tax rates
 Elasticity of substitution among goods pins down steadystate markup: PY
Y MC

P
Y  1 P
Y  1
,
 Higher substitutability → lower markup → higher
production (for given price)
 Capital income tax rate affects steady-state investment:
r
K
1   
K

1   1   

PI
 Labor income tax affects steady-state labor supply:

W
1 
P


L
L  1
 1 L ,
L  1
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Potential output and structural reforms after the crisis in Italy
Calibration
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Potential output and structural reforms after the crisis in Italy
Fiscal consolidation scenarios
 A permanent reduction in debt-to-GDP ratio targeted by
fiscal authority
 bg decreases from 119 to 109%
 Fiscal instrument fit is labor tax rate
(l=43%) or capital tax rate (k=35%)
 Gradually (over 12 yrs)
 Fully anticipated and credible
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Potential output and structural reforms after the crisis in Italy
Structural reform in ITA services
 A permanent reduction in price markup in the nontradable
sector
 Price/cost ratio decreases from 1.29 to 1.19
 Reform size reproduces the 2011-12
wave of competition-enhancing reforms
in Italy
(details)
 Implemented gradually over 5 yrs
 Fully anticipated and credible
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Potential output and structural reforms after the crisis in Italy
 Fiscal consolidations increase potential output via lower interest
payments and hence lower taxes to finance them.
 Competition-friendly reforms in services are very effective:
improvements in price competiveness stimulate exports; real rate
increases boost investment.
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Potential output and structural reforms after the crisis in Italy
But in the short run fiscal consolidations are painful…
using labor tax rates
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Potential output and structural reforms after the crisis in Italy
… sometimes very painful …
using capital tax rates
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Potential output and structural reforms after the crisis in Italy
… while structural reforms boost investment!
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Potential output and structural reforms after the crisis in Italy
A comparison with Eggertsson, Ferrero & Raffo (2013)
 Structural reforms in this “baseline” (no crisis) scenario have opposite
implications for consumption and the real rate with respect to EFR.
 Real rate increases because Italy is small and ECB is not responding
much to its deflation (estimated Taylor rule)
 Higher real rates depress consumption but boost investment (not
present in EFR)
 Thus, structural reforms ended up increasing output in both models but
through different channels
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Potential output and structural reforms after the crisis in Italy
The magic of “fiscal discipline”
 When SR are implemented together with a fiscal consolidation, effects
are much more than additive
 SR + labor-tax consolidation:
+ 5.3 percent (instead of 0.3)
 SR + capital-tax consolidation:
+ 10.4 percent (instead of 1.2)
 Why? The extra output from SR is “seized” by the fiscal rule and used
to reduce tax rates (much) more aggressively than before:
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Potential output and structural reforms after the crisis in Italy
Mild recession in the first year, then a boom.
Consolidation via labor tax rates & services reform
Potential output and structural reforms after the crisis in Italy
Crisis scenarios
 When reforms are implemented in the aftermath of a crisis their shortrun impacts can be counterproductive
 To simulate a crisis we made two changes:
 Sovereign risk channel: Italian sovereign rates are a spread over EA
risk-free rate (Corsetti et al. 2012) & are sensitive to the fiscal stance:


R Ita  R  f  E
t
t
t


bg

 t  1 


g
 b

 t 
 We experiment with a 75 bp (temporary) reduction
 Italian hhs inherit the sovereign spread quickly and fully (Albertazzi et al. 2012)
 Constrained monetary policy: official rates stay put for 2 years … from
the 3rd year on, we are back to Taylor
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Potential output and structural reforms after the crisis in Italy
Fiscal consolidations in time of crisis
 A 75 bp (temporary) decline in spread increases output by 0.3 p.p.
 Constant MP adds nothing
Labor-tax consolidation under a sovereign risk channel and constant MP
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Potential output and structural reforms after the crisis in Italy
Structural reforms in time of crisis
 No relevant changes. And this is a result! (again, EFR 2013)
Labor-tax consolidation plus services refom
under a sovereign risk channel and constant MP
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Potential output and structural reforms after the crisis in Italy
Main policy message
 Fiscal consolidations plans increase potential output but
have sizeable costs in the short and medium term.
During/after a crisis are not such a good idea.
 Supply-side competition-enhancing reforms during/after a
crisis are not a bad idea for a “small” periphery country in
the EA.
 An excellent IdEA is actually to do both at the same time.
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A model-based evaluation of structural reforms in Italy
Structural reforms in Italy (since July 2011) (1/3)
• Increasing competition in service markets
– Professional services: abolish (min and max) fees and free
advertising; reduce maximum length of training; (for Notaries:
increase entry);
– Network services: creation of Authority for transport, unbundling
measures for energy;
– Retail sector: liberalization of opening hours.
• Reducing administrative burdens
– Specific measures: ease (esp. youth) entrepreneurship lowering
entry costs and capital requirements; reduction of administrative
burdens for specific activities;
– Horizontal measures: introduction of “regulatory budgets” (no
new regulatory provisions without eliminating previous ones) and
“substitute powers” (designated top public officials are
responsible for PA non-compliance).
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A model-based evaluation of structural reforms in Italy
Structural reforms in Italy (since July 2011) (2/3)
• Labour market reform
– Measures lowering costs of individual dismissal (art.18):
• reduces and specifies cases for reinstatement; strictly caps
payments in case of unfair dismissal; introduces faster judiciary
track;
– Measures addressing segmentation
• Reduces fiscal incentives to hiring workers on some types of
non-permanent contracts; extends the cooling-off period
between two fixed-term contracts; curbs abuses of non
standard arrangements.
– Welfare and active policies
• A unique Unemployment Insurance instrument with longer
duration and larger pool of beneficiaries but also stronger
conditionality & monitoring
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A model-based evaluation of structural reforms in Italy
Structural reforms in Italy (since July 2011) (3/3)
• Judicial system
– Organization measures: create specialized courts for company
law issues; rationalize number and spatial distribution of first
instance courts;
– Measures to reduce litigation: increase court fees; introduce
compulsory conciliation in a number of claims; restrict the access
to appeals and highest courts.
• Infrastructures
– Measures to simplify procedures (esp. for “strategic
infrastructures”) and encourage the involvement of private capital
(e.g. issue of “project bonds”); strengthen anti-corruption
monitoring.
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A model-based evaluation of structural reforms in Italy
OECD Product Market Regulation indicators for
services in Italy
 After the reforms, service regulation in Italy should be
no larger than OECD average
3.5
3.2
2.9
OECD Mkt Regulation Indicators
3.0
2.5
2.1
2.2
2.3
2.3
2.1
2.2
2.2
1.9
2.0
2.2
2.0
1.6
1.6
1.5
1.0
1.0
0.5
0.0
Professional Serv.
Retail
OECD 2008
Transport
ITA 2008
Communications
Energy
ITA 2012 (BI forecast)
Note: PMR indicators take values between 0 (best regulation) and 6 (worse)
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A model-based evaluation of structural reforms in Italy
A four-steps procedure
 Update the OECD indicators of market regulation
 Estimate a mapping between OECD indicators
and model objects (markups, productivity, etc …)
 Apply the estimated coefficients to the OECD
indicator update
 Obtain estimated changes in service markups
and in service productivity to be used as shocks
when simulating the DSGE model
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