12° Macroeconomic Policy Research Workshop Magyar Nemzety Bank, 19-20 September 2013

1. Potential output and structural reforms after the crisis:the case of ItalyAndrea Gerali, Alessandro Notarpietro, Massimiliano Pisani 12° Macroeconomic Policy Research Workshop Magyar Nemzety Bank, 19-20 September 2013

2. 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 Potential output and structural reforms after the crisis in Italy 2

3. 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) Potential output and structural reforms after the crisis in Italy 3

4. 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 Potential output and structural reforms after the crisis in Italy 4

5. 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 non-tradables (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 Potential output and structural reforms after the crisis in Italy 7

6. Model: fiscal block Fiscal policy at regional level, government budget constraint: Italian fiscal rule: fit (either tax rates, lump-sum transfers, public C) responds to (i) distance of debt-to-GDP ratio from target and (ii) deficits Potential output and structural reforms after the crisis in Italy 8

7. Model: markups and tax rates Elasticity of substitution among goods pins down steady-state markup: Higher substitutability → lower markup → higher production (for given price) Capital income tax rate affects steady-state investment: Labor income tax affects steady-state labor supply: Potential output and structural reforms after the crisis in Italy 9

8. Potential output and structural reforms after the crisis in Italy Calibration

9. Fiscal instrument fit is labor tax rate (tl=43%) or capital tax rate (tk=35%) Gradually (over 12 yrs) Fully anticipated and credible A permanent reduction in debt-to-GDP ratio targeted by fiscal authority bgdecreases from 119 to 109% Potential output and structural reforms after the crisis in Italy Fiscal consolidation scenarios

10. Reform size reproduces the 2011-12 wave of competition-enhancing reforms in Italy Implemented gradually over 5 yrs Fully anticipated and credible A permanent reduction in price markup in the nontradable sector Price/cost ratio decreases from 1.29 to 1.19 Potential output and structural reforms after the crisis in Italy Structural reform in ITA services (details)

11. 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.

12. Potential output and structural reforms after the crisis in Italy But in the short run fiscal consolidations are painful… using labor tax rates

13. Potential output and structural reforms after the crisis in Italy … sometimes very painful … using capital tax rates

14. Potential output and structural reforms after the crisis in Italy … while structural reforms boost investment!

15. 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

16. 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:

17. 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

18. When reforms are implemented in the aftermath of a crisis their short-run 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: 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 Potential output and structural reforms after the crisis in Italy Crisis scenarios

19. 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

20. 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

21. 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.

22. 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 officialsareresponsible forPA non-compliance).

23. 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

24. 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.

25. 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 Note: PMR indicators take values between 0 (best regulation) and 6 (worse)

26. 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