This article originally appeared in
No. 207
Thursday, October 25, 2006
                                                             Page J-1
ISSN 1522-8800                                                                        Analysis & Perspective

International Taxes
Italian Prime Minister Forced to Rethink Planned Tax Increases to Balance Budget

ROME--Public opinion and doubts among political allies are forcing Italian Prime Minister Romano Prodi to reconsider plans to
increase taxes as part of a broader deficit-reducing scheme built into next year's budget.

After years of tax breaks and a growing budget deficit under the leadership of former Prime Minister Silvio Berlusconi, Prodi took
power in May promising to reduce Italy's deficit to within European Union limits with a combination of spending reductions, closing tax
loopholes, and tracking down tax cheats.

The strategy has so far yielded positive results: through the first three quarters of the year, tax revenue is 12 percent higher than
during the equivalent period in 2005--a trend the government says is due in large part to the new policies (199 DTR G-5, 10/16/06  ).

Despite the early success of the new policies, Prodi has warned in the months since taking office that he would not adopt a less
aggressive policy toward trimming the country's debt, and he announced a series of forthcoming measures that include a variety of tax

  • reforming corporate income taxes in a way that will require most small- and medium-sized firms to pay more;

  • raising taxes on capital gains to 20 percent from 12.5 percent;

  • increasing income tax for households earning more than 40,000 euros ($50,800) per year;

  • re-establishing the estate tax; and

  • allowing cities to establish separate tourist taxes.

Incentives for Avoidance?

While Prodi has continued with his plans to increase revenue by pursuing tax cheats, economists warned that raising taxes often acts
as an incentive for more companies and individuals to try to find ways to avoid paying taxes.

"Individually, I think none of these changes would have attracted much attention, but together I think they have undermined Prodi's
claims of being a reformer and allowed the opposition to cast him as someone eager to raise their taxes," University of Bologna
economist Tilio Bataglia told BNA.

Despite the measures, both Fitch and Standard & Poor's downgraded Italian debt Oct. 18. Both firms said Italy's inability to
aggressively address its burgeoning debt problems was a central reason for the downgrade.

"The more the debt grows, the more it is likely that Italy will have future difficulties satisfying it, and that is what the downgrade
reflects," a Fitch spokesman said in an interview.

Protests Rock Nation

Italians responded to the ongoing problems by taking to the streets, blocking Italy's largest cities with staggered street protests earlier
in October, and sending Prodi's approval levels to below 40 percent.

For the first time, members of Prodi's coalition have begun second-guessing their leader in public. Several legislators and at least
two ministers have in recent weeks begun publicly criticizing the prime minister.

On the record, Prodi said he is not concerned and that by closing the budget deficit, streamlining government, and pushing through
reforms he will spark increased growth in the moribund Italian economy. But his actions indicate changes may be in the works.

Prodi, a former European Commission president, called a strategy meeting for his coalition for Oct. 28, designed to get his fractious
coalition to toe the official line on tax-related issues before the controversial budget heads to Parliament for a vote, where his coalition
holds razor-thin majorities in both houses.

The conventional wisdom is that Prodi will have to reverse some of his reforms to win back popular support and backing within his

"Put it this way, if the budget was voted on today as it stands at this point, it would not have a chance," Javier Noriega, chief economist
with investment bankers Hildebrandt and Ferrar, told BNA.

ABS Securities analyst Angelo Mertz said the problems are proving more complex than many predicted.

'People Want to See Progress'

"It's unreasonable to expect a government to start yielding concrete growth in just a few months after taking power because the
issues are so complicated and ingrained," Mertz told BNA. "But despite that, people want to see progress. They want to believe the
problems will be solved."

Mertz has run models predicting that without tax increases, unexpected growth, or severe spending cutbacks, the country would be
unable to reduce debt to within the EU-mandated target of 3 percent of the country's gross domestic product before at least 2009,
compared to the target of reaching that point from the current estimate of 4.4 percent of GDP by the end of next year.

One way of forcing agreement on the controversial new policies, according to analysts, could be calling a risky confidence vote in

The strategy was used several times during Berlusconi's final two years in power, but the stakes are high: if Prodi wins such a vote,
his unpopular reforms would carry through. But if he fails, he would have to resign.

Prodi has already called seven confidence votes since taking power, but none over an issue as contentious as the budget-related

Prodi's spokesman told BNA that a confidence vote is not in the cards at the moment but that it "remains an option" if the landscape

EU Backing

Prodi's plans are not without backers: European Union Economic and Monetary Affairs Commissioner Joaquim Almunia concluded
two days of meetings with key government officials including Prodi, Minister of Finance Tommaso Padoa-Schioppa, and Central
Reserve Bank head Mario Draghi Oct. 23, applauding the ongoing reforms but cautioning that more work is needed.
Fitch, meanwhile, said Italy could be a candidate for a quick debt rating upgrade if the reforms achieve the ambitious debt-reducing
results Prodi promised, though that would be unlikely before the middle of next year.

But among Italians, Prodi's plan remains a tough sell.

"We have conducted six polls in five months in which we questioned Italians about their support for the prime minister's economic
reform plans and in every poll the support has dropped compared to the previous poll," Maria Rossi, co-director of the Rome-based
polling company Opinioni, told BNA.

That is a trend that even Prodi's allies said cannot continue much longer.

For the time being, however, they insisted that the prime minister can stick with his planned reforms and continue to hold onto power.
But economists said that the coming weeks are likely to decide whether he will be forced to pick between those two options.

By Eric J. Lyman
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ISSN 1522-8800
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