Italy’s Taxes Drive Economy Underground

Milton Friedman used to say that “for many years Italy did well because of the black market.” Italy grew rapidly over the 20^th century, and its black market was part of an important economic recovery after World War II. Italians made everything from low- cost toys to high-quality cars, and from world-renowned coffee to thousands of movies. However, in 2018 Italy is one of only two European countries where GDP per capita has not recovered from the financial crisis. Italy has an unemployment rate of 11 percent and a youth unemployment rate of about 35 percent. In addition, Italians have the second largest government debt in the world relative to their GDP.

Italy’s problem, similar to many of its southern-European neighbors, is an oppressively high tax burden, irresponsible welfare programs that encourage high measured unemployment and increase the debt, and high levels of regulation. Consider Italy’s performance compared to Germany. Italy went from being 2 percent poorer than the Germans in the year 2000 to 21 percent poorer in 2017, therefore its gap widened by 19 percentage points. One reason for this might be that Germany grew faster because it made reforms and became more competitive, while many other European countries did not.  The gap between Portugal, Spain, and Greece and Germany widened by 2 percent, 3 percent, and 16 percent respectively. Therefore, Italy’s gap with Germany widened the most.  

Alternatively, a stronger explanation for Italy’s underperformance is its tax and welfare systems, together with its budget deficit and regulations. While Germany implemented the “Agenda 2010” in 2003, a plan that reduced welfare benefits, regulations, taxes, and the deficit, Italy increased its debt and has not meaningfully changed policies.

Today the share of average wages collected by the Italian government via income and social security taxes is among the highest in the OECD at 48 percent. In addition, Italy imposes a value-added tax of 22 percent on most goods and services, one of the highest in Europe. Plus, Italy’s corporate, capital gains, gift, and myriad other taxes are passed on to individuals and borne directly by workers. These high taxes lead to a growing shadow economy, where people underreport work to avoid paying taxes. Many Italians save their income from tax collectors by illegally working in construction or services, transferring an apartment before the death of a relative, and hiding savings from the wealth tax in Swiss bank accounts. Italy’s shadow economy is about 21 percent of its GDP, compared to Germany’s, which is about 12 percent of its GDP.

Therefore, while Italy is 21 percent poorer than Germany in official terms, it is only 15 percent poorer when the shadow economy is accounted for since its shadow economy is larger. Moreover, many estimates point to more than  $175 billion (€150 billion) in lost tax revenue, enough to more than close Italy’s budget deficit. Higher taxes both depress economic activity and encourage greater tax avoidance. While this may sound good for the those who hide their income from taxation, not all activities can be transferred into the shadow economy, nor can the activities that are transferred operate like before.

Another reason for the weak employment situation is that workers are entitled to earn up to $1,510 (€1,300) per month for up to two years of unemployment depending on how much they earned and how long they have been unemployed. If a legal low-paying job is offered, the unemployed have two choices: lose unemployment benefits and pay almost half their income in taxes, or work in the shadow economy, keeping unemployment benefits, earning money, and evading taxes. It is understandable why so many Italians would rather stay unemployed. Countries with more generous unemployment insurance programs not only have longer average unemployment durations but also higher levels of unemployment.

At the same time, Italy’s complex regulations are a barrier to starting or continuing productive activities. A study by economist Raffaela Giordano of the Bank of Italy concluded that the main reason behind Italy’s underperformance was burdensome regulations and corrupt and inefficient government structure. Higher costs related to opening a business lead to fewer recorded businesses.

Instead of cracking down on tax evasion and the shadow economy, Italy’s new government needs to rethink long-standing policies to bring a real economic recovery. Taxes need to be lowered so more businesses open and already-existing businesses and individuals come out of the shadows, broadening the tax base and raising revenue. This would allow those in the shadow economy to expand their businesses. Additionally, the welfare state should be trimmed so that people do not have an incentive to stay unemployed and young Italians are less burdened by government debt. Moreover, Italy needs to become more competitive by slashing the number of regulations. These pro-growth and fiscally responsible policies would bring a drastically lower unemployment, higher wages, and a more prosperous society.

Daniel Di Martino is a contributor to Economics 21. Follow him on Twitter @DanielDiMartino