Italy has undertaken broad structural reforms aimed at improving its weak economy by addressing bottlenecks in product and labor markets. Product market reforms focus on increasing competition through deregulation, while labor market reforms aim to make the labor market more dynamic and inclusive. Simulations suggest that fully implementing these reforms could increase Italy's GDP by over 10% in the long run by reducing prices, boosting productivity, and increasing labor supply. Combining product and labor market reforms has a greater effect than implementing either set of reforms alone. Further fiscal reforms like shifting taxes from labor to consumption could also promote growth.

1. Assessing the Macroeconomic Impact of
Structural Reforms: The Case of Italy
ABU MUSA NSAMBA 902007
Introduction
Italy’s economy has a number of important strengths. Italian households have sound balance sheets, and private savings have
traditionally been high. Private debt at nearly 125 percent of GDP, which is among the lowest in the Euro area despite its Public
sector, having one of the biggest debts in the worldhas large assets too withforeignliabilitiesat around 20 percent of GDP. Italy’s
net international investment is more favorable thanin other Euro area peripherycountries. Despite these strengths, Italy’s economic
performance has lagged behind growth averaging less than a half percent in the last decade while total factor productivity wa s
negative. In absence of major changes potential growth is likely to remain close to zero over the medium term.
Broad rangingstructural reforms are underwayin Italy, aimedat addressingbottlenecks in the product andlabor markets. That have
hindered potential gains for the economy in the past few years.
Italy’s weakperformance hasbeenattributedto numerous structural factors, i.e. Limitedcompetition withregulatoryrigidities and
entrybarriers that have kept rents high inthe non-tradable sectors. This has affectedthe business environment, increasingcosts for
the sectors that need to compete globally, hence dampeningthe competitivenessof the economy, bringingabout low firm growth,
low economies ofscale, limiting innovationandforeigndirect investments leadingto a loss inexport market shares. The labor market
is marredbylow participationcausedbyhighlabor adjustment costs andpoor female representationinthe labor market, dualism,
low internal flexibility and low educational attainment. Inadequacies in the labor market have been accentuated by the high tax
burden, coupledwith inefficient public spending, a lengthylegal system, regional disparitiesand a sizeable unofficial economy.
Important steps have been taken in full scope of structural areas in order to lower cost of managing business and its labor market
reforms to make the labor market more dynamic and inclusive.
The assessment of the potential impact of these reforms will be explainedusing the various models basedapproaches, highlighting
the mainstructuralproblems andcontrasting them withthe actions proposed. In thispaper I put more emphasis onThe benchmark
reforms inassessing the impact as theyhave andare inimplementationprocess andthiswouldgive us a realpicture ofthe potential
impacts.
Product Markets: Deregulation and Enhancing competition
In general, the measures aimto address excessive monopolistic rents, reduce barriers to entryandinformationasymmetries as well
as remove unnecessaryregulations for economic activities. Theyaddresssome ofthe keyregulatoryshortcomings from the 2001
constitutionalreform that re-allocatedsignificant legislative andregulatorypowers to subnational authorities in commercial
distribution, energyandTransport. Together, these sectors amount to about one third of totalvalue added inthe economyand
contribute about 40percent of total inputs used(intermediate consumption)byother industries andclose to 30 percent of
household’s final consumption expenditure.
The Case of the Energy Sector
Italy’s energyprices are among the highest in Europe,particularlyelectricityits prices are 50 percent higher thanthe European
average, especiallyfor industrialusers. In the gas sector, the limited import infrastructure, the existence of strong incumbent ENI in
all segments of gasimportation, storage, transportationand longterm import contracts have hamperedcompetitionand
discouragedinvestments. Achieving coordination of the projects of national interest is complicated by the veto powers of regional
or local governments whose authorizationof procedures are verylong. Pricesof petroleumproducts with and without taxes are
also highest in Italyas a result ofoutdatedandoversizeddistributionnetwork, barriers to entryandcontractual restrictions.
To open upthe gas sector to competitionandpromote infrastructure investments, the authoritiesstarteda processof separating
the ownershipof gas transport/storage providers from ENI. Measures are alsobeing put in place to address the delays inthe
authorization process for strategic infrastructure projects, promote investments ingas andelectricitysectors and reduce potential
supplyshortages andthe cost of gas for companies byprovidingaccess to storage. Some restrictions on exclusive contracts
betweenfuel distributors andsuppliers have beenliftedwith measures to enhance information transparencybeing introduced.

2. The Case of Professional Services
Italyhasone ofthe most restrictive regulations in professions among the OECD countries withlimited competition, restricted
supply, protecting incumbents rent andincreasedcosts for businesses and households. Entryto andconduct inthe market are
subject to stringent controlsalong withprice regulations example being the Pharmacists whoare particularlyheavily regulated.
Regulations inlegalservices create uncertaintyabout the ultimate costs of resorting to the justice system.
Past attempts to reformprofessional servicesfacedstrong resistance anddidnot always move inthe directionof deregulationand
increasingcompetition. The latest reforms have proposedabolishingtariffs for regulatedprofessions except for cases of judicial
settlement of compensations for which parameters establishedbythe justice ministryare to be used.
Labor Market: Improving Participation and Productivity
Makingthe labor market more dynamic and inclusive have beenthe mainobjectives of the authorities’ reform. The labor reform
bill, which was approvedbyparliament in 2012 addresses the most keyaspects of the labor market, tacklingjobinsecurityand
dualism, makingemployment protectionandinsurance more even andencouraging stable employment relationships while
lowering firing costs andultimatelyincreasingemployment and participation especiallyfor the youth.
When assessingthe reforms, a number of observations emerge. First, inthe measure ofproduct market reforms, there are
measures that go inthe right direction ofincreasingefficiencytheir impact will dependentirelyon how theyare implemented.
Secondlythere are measureswhichare more ofanincrementalnature and donot provide a clear shift from current labor
arrangements suchas the case of policies to address dualism betweenpermanent and temporaryworkers. As there is a mismatch
betweenwages and productivity growth. Italy’s aggregate wage is toocompressed, in starkcontrast to large regional differencesin
productivitythe significant mismatch between wage and productivityhas increasedunit labor cost inItaly’s manufacturing sector
since 2000, well above that of GermanyandFrance. Several options canbe pursuedto strengthenthe labor market reform further
for example bridging the gap betweenpermanent and temporaryworkers that graduallyincrease employment protectionwith
tenure couldbe considered. Thiswouldencourage hiringbylowering the cost ofnew regular hires, remove discontinuity infiring
costs that employers face, reduce incentives for excess turnover in favor of longtenuresand skill accumulation, more could be
done to boost female labor participationwhich is one of the lowest in the OECD, suchas byreducing the marginal tax rates for
second marriage earners.
The Benchmark Scenario of Structural Reforms
In particular, for product markets, we consider the comprehensive package ofthe liberalizationreforms discussedinSection II that
could increase competitionandproductivity, especiallyinnon-tradablesector. In addition to the specific sector-specific measures
outlined in Table 1, this package incorporatesalso the plans to liberalize all other economic activities, including those subject to
sub-national government regulations. Inthe package oflabor market reforms, we include the policiesthat aim at increasing the
efficiencyinthe labor market andboostinglabor participation. The former consists of the measures to lower adjustment costs
through easing employment protectionlegislationand improving job matching bystrengtheningactivationpolicies. The latter
focuses onthe policiesto increase female employment. All product and labor market reforms in the benchmarkscenarioare
assumedto be stepwise credible. The specific reform measures and proxies usedin the simulations are reportedin Table 3.
The keyassumptionhere is the extent to which the specific reforms couldtranslate into meaningful changes in the structural
parameters that affect the economy, suchas the price markups, productivity, andlabor supply. In the benchmarkscenario, we
assume that the reforms will close roughlyhalfthe gap betweenthe current situationin Italyanda best practice measure—the
OECD for labor markets andrest ofthe euro area for product markets—over a five-year period(Table 3). This assumptionmaystill
be ambitious, especiallyfor product market reforms, considering deeply-rootedstructural problems. We explore alternative
assumptions for the mapping ofthe reforms onto the changes in the modelparameters inthe sensitivityanalysis. NRP(2012),
instead, assumesthat recent liberalizationandsimplificationmeasureswill have a similar impact onprice markups andbusiness
costs as estimated in the case of major structural reforms inthe past. Implicitly, NRP(2012) assumes that the implementation of
current reforms mayyieldsubstantial benefits interms of increasingcompetitionsimilar to those experiencedacross Europe as a
result of the wave of product market reforms undertakeninthe late 1980s and1990s
Productmarketreforms
These are to leadto greater competition and are expectedto reduce the level of economic rents, bring prices closer to marginal
costs i.e. reduce markups, improve resource allocationandcreate incentives to undertake more productive activities. These
policies include eliminationof restrictions on economic activities reducing businesscosts suchas energyand administrative costs
providing transport and other local public serviceson a more competitive basis reducing involvement inthe economyandwhile this
is a special case inthe non-tradable sector it can potentiallyhave a twofold effect similar to other sectors, competition and
deregulationmeasures will reduce input costs for businessesandhouseholdthat use professional services. On the other hand, such
measures will likelyinvolve opening upsegments ofthe labor market thus having alsoa direct impact onthe labor market and
wages for example when reforms are aimed at easing supplyrestrictions like the number of notariesor taxi licenses or deregulate
and reduce tariffs for services like inthe case of lawyer’s compensation

3. Simulations have suggestedthat increasing competitionin non-tradable sector andtradable one wouldincrease output by4
percent in 5 years and7.7 percent in the long run. Greater completionwouldreduce the cost ofgoods and services to consumers
leading to anincrease in consumptioninvestment andexports by9,6.5, and5.8 percent respectivelyin the long run. Increased
demandfor goods wouldincrease the firms demandfor factors ofproductionthiswouldput upward pressure onreal wages which
wouldincrease by7.3 percent inthe longrun. Hours workedwould be slightlylower inthe longrun as the stronger income effect
outweighs the substitutioneffect. The economy’s competitiveness wouldimprove inthe long runwith labor productivityalmost 8
percent higher unit labor cost would decline and real exchange rate would decline by3.5 percent.
The results for the medium term differ from the long term impact since markup reductionprocess wouldbe still ongoing over the
medium term andagents wouldonlygraduallyaccept that the shift inpoliciesis permanent. Exports wouldbe weaker inthe long
run while imports wouldbe roughlysimilar but consisting more of investment goods.
Labor MarketReforms
These reforms focus onadjustment costs andon labor supplywhichinclude reducing costs of labor adjustment for the firms which
is expectedto improve resource allocationandlabor mobility, therebyhaving a positive impact on productivity.
Encouragingthe unemployedor thoseno longer participating inthe workforce to retrainto fields with greater employment leading
to an overall increase inlabor supply. This is modeledas anincrease ingovernment spending for the active labor market policies
programs that offset bya reductionintransfer to other households. Increasing the availabilityof childcare available to women
through increased government spending.
The labor market reforms wouldhave a positive but relativelysmaller impact on output. These reforms would increase either
productivityor labor supplywhichbehave similarlygiventhat both are supplyside factors inthe economy. In the long run real GDP
wouldincrease by1.8 percent withmost of the increase drivenbyreforms that boost labor supplyparticularlythrough higher
female participation. As labor supplyincreases labor productivitywould deteriorate slightlyin the longrun but unit labor cost
wouldstill be lower since wageswoulddecline by more. With more labor available for productionfirms demandfor capital would
also increase andinvestment wouldbe permanentlyhigher by1.5 percent. Thiswouldleadto a permanent real depreciationof
almost 0.7 percent and a slightlystronger external position.
After 5 years real GDPgains relative to baseline wouldbe 1.1 percent. Since inthe mediumterm households wouldhave perceived
the changes in the policies regardingactive labor market policiesandchildcare as temporarytheywouldnot fully commit to
supplying more labor. Wages wouldfallonlyby0.9 percent more thanin the longrun since the positive effects of higher demand
for Italiangoods andhence for production factors would stilltake time to materialize.
The relativelymodest impact ofthe labor market reforms reflects several factors. First, inthe areasof employment protection
legislation, active labor market policies, and childcare services, Italy, according to the OECD estimates, is not as far off frombest
practices.
Second, the effects of these reforms onproductivityandGDPare empiricallyfoundto be relativelysmall(e.g., Barnes and others,
2011; Bouis andDuval, 2011), evenmore sowhen government spendingassociatedwith these measures (in case of ALMPand
childcare) are offset as assumed in our simulations. Third, in the short run, their impact is muted becauseof the assumedstepwise
credibilityof the reforms (per design ofthe exercise) such that the future shocks are not fullytaken intoaccount inhouseholds ‘and
firms ‘decisions inthe first years.
As the labor market becomes more efficient andcompetitive labor supplywouldincrease bothinthe medium and long run. Real
wages would decline beyondjust the fall inthe wage markupandthere wouldstill be some smallcompetitiveness gains especially
in the mediumterm.
CombiningProductandLabor MarketReforms
Implementingthe product and labor market reforms together couldraise real GDPinItalyby5¾ percent after 5 years andby10½
percent in the longrun. The reforms with the greatest impact would be those that affect the competitiveness of the non-tradable
sectors given the assumedlarge reductionin markups to close halfof the gap withthe rest ofthe euro area. As mentioned, the
impact of labor market reforms wouldbe more modest but still not inconsequential.
There appears to be a payofffrom doing all product andlabor market reforms simultaneously. Product market reforms would
stronglyboost consumption evenas labor market reforms act as a drag, especiallyinthe short run. Hours workedwouldincrease in
both the mediumandlong term, reflecting the impact of labor market reforms, and real wageswouldstill be higher despite
downwardpressure from the labor market reforms. Unit labor cost woulddecline, anda strong labor productivityincrease, driven
byproduct market reforms, would dominate. The real exchange rate depreciation and terms-of-trade deteriorationwouldbe
stronger whenthe reforms are combined the recent findings byOECD (Cacciatore andothers, 2012) arguingthat inthe longrun
there might be substitutability, rather thancomplementarity, betweenproduct andlabor market reforms.

4. The reforms inItalywouldhave positive but small effect onthe rest ofthe euro area since most significant reforms take place in
the non-tradable sector. Over the mediumterm, real GDPin the rest of the euro area wouldincrease byjust 0.3 percent. Still, the
purchasingpower of households in the rest of the euro area wouldincrease as Italy‘s real exchange rate depreciates, the terms of
trade deteriorate, and its exports become cheaper. The exports fromthe rest ofthe euroarea to Italywouldincrease as the
aggregate demand inItalypicks up.
When product and labor market reforms inItalyare implementedinthe context of wider euroarea product market reforms, the
gains for Italywould increase. As in the case of Italy, there wouldbe anincreaseddemandfor imports inthe rest of the euroarea,
as households become wealthier inthe long run. Since Italyhas strong trade linkages withthe rest ofthe euro area, exports from
Italywouldincrease to meet increased euro area demand. Overall, Italy‘s realGDPwouldbe 1.7 percent higher over the medium
term from the reforms implementedin the rest of the euro area, andtogether with the domestic structural reforms, its output
wouldincrease by7.5 percent. Note that the combinedeffect is slightlyhigher than the sum of the reforms inthe two regions
taken separately, supporting further the benefits of reform coordinationin the euroarea.
Additional LaborMarketand Fiscal Reforms
For the reforms inthe fiscal area, two types ofreforms which would—ina deficit-neutral way—lower the labor tax wedge and
increase infrastructure spending are considered.
• Shifting taxation from direct to indirect taxes: Lowering bothlabor and corporate taxes, offset bybroadening the VAT
base.
• Shifting expenditure from transfers to investment:Shifting expenditure compositionfromgeneral lump-sum transfers to
productive, well-targetedinfrastructure investment.
A tax reform to shift taxationfrom direct to indirect taxescouldpromote growth, hours worked, andexports. Inparticular, a tax
reform package, whichlowers bothlabor andcorporate taxes (by2 percent of GDPcombined), offset bybroadening the VAT base,
could raise GDPrelative to the baseline 0.5 percent onimpact and byup to 2 percent in the long run. Hours worked, after a positive
short-term reaction, will be marginallyhigher inthe long run(althoughthe realwage will increase by1.3 percent). Exports will rise
byabout 1.5 percent inthe longrun, while the real exchange rate willdepreciate byless than 1 percent. While an increase in
consumptiontaxeswill lower the amount consumedbyhouseholds, the distortions removed byloweringcorporate andlabor
income taxesare much greater. Moreover, the labor income tax cut will offset the negative effects from consumption taxes on
households ‘spending power andwill provide an incentive for more labor supply. The corporate income tax cut will reduce the cost
of capital faced byfirms, encouraging greater demandfor capital, investment goods, andlabor.
An expenditure reform to shift government expenditure fromtransfers towards investment (by1 percent of GDP)wouldproduce
larger gains. Spendingon productive, well-targetedinfrastructure has the greatest return:insteadof the fiscal outlayjust entering
real GDPon impact for that year, it improves the stock ofinfrastructure (for example, inkeynetworkindustries) inItaly, makingall
sectors more productive as a whole. Bycombining fiscalreforms withproduct andlabor market reforms, real GDPin Italycould
increase byabout 8½ percent after 5 years andalmost 22 percent inthe long run. Implementing a comprehensive package of
structural reforms couldcontribute to closing
Italy‘s competitiveness gapaccumulatedover the past decade. Inparticular, IMF ‘s estimatessuggest that the competitivenessgap
(real exchange rate overvaluation) couldbe of the order of 5-10 percent. Simulations suggest that the above discussed structural
reforms, especiallyin product markets andfiscal reforms, could result inrealexchange rate depreciationof close to 3 percent after
5 years andover 7 percent in a decade. Unit labor cost would decline, byjust about 4½ percent after 5 years, as increasedlabor
productivitymore thanoffsets the increase inwages. Inthe short run, however, the current account woulddeteriorate reflecting
higher investment relative to private savings. In the medium term, real exports rise faster than real imports, althoughreal imports
wouldaccelerate inthe short run from stronger investment that is taking advantage oftax reform andproductivitygains. In
addition, the price shift fromthe depreciation (terms oftrade deterioration)wouldadversely affect the nominal trade balance. In
the long run, however, current account wouldconverge to zeroandturn slightlyintosurplus.
In sum, a combinationof structural reforms inthe product market, labor market andfiscalsector will produce long-rungains for
the Italianeconomy. These effects couldbe reinforcedif the rest of the euroarea engages insimilar reforms simultaneously. Also,
there will be positive feedbackeffects acrossthe different types of reforms, as demonstrated particularlywiththe labor an d
product market reforms. Moreover, the fiscalreforms couldprovide positive feedbackeffects for labor market reforms, as theyuse
manyof the same channels, particularlyproductivity, andcould provide a stimulus for greater consumptionandlabor supply.
Comments
The outcome of these reforms will depend onhow exactlytheywill be translatedto practice bythe authorities and the response to
them bythe public interms oftheir consumptiontheir provision oflabor. I firmlybelieve theyare achievable but with a long term
political mandate as these reforms projections as we have seenabove will fullybenefit Italyinthe long term.