By Alvise Lennkh-Yunus and Giulia Branz, Sovereign and Public Sector

Italy’s fiscal deficit figures have been significantly revised upward to 9.7% of GDP from 9.5% in 2020, 9.0% from 7.2% in 2021, and to 8.0% from the government target of 5.6% in 2022, following the Italian Statistical Office’s (ISTAT) data revision, driven by Eurostat’s recent clarification on the accounting treatment for tax credits.

According to Eurostat, when tax credits can be freely transferred to third parties, their cost must be recognised in full when granted rather than when used (and thus spread over time as previously assumed by the Italian authorities). The very large impact on Italy’s fiscal deficit figures results from the widespread use of tax credits related to building renovation bonuses, including those related to the “Superbonus 110” programme.

This was a flagship policy introduced by the 5 Star Movement-led government in 2020 to support economic recovery from the pandemic, which allows for a generous tax deduction (110% of the amount, originally) of expenses for building renovations and energy efficiency.

In response to Eurostat’s clarification, the Italian government has decided to stop the transferability of new tax credits, preventing the current practice of these credits being sold between households, construction companies and financial institutions. This practice incentivised renovation works, with the construction sector growing by over 10% last year and by close to 21% in 2021. The Bank of Italy estimates that about half of the renovation investments would not have been carried out without the bonus.

The government’s decision will re-classify tax credits such that their costs are now spread over multiple years. In addition, they will likely reduce the use of the bonuses, and thus their final cost to Italy’s public finances. This will ultimately support the government’s ability to meet its fiscal deficit targets of 4.5% of GDP for 2023 and 3.7% for 2024, without the need to implement additional spending cuts.

Figure 1 – Revision of Italy’s general government fiscal balance
% of GDP

Source: Istat, Nadef 2022, Scope Ratings

Future costs of bonuses likely contained but economic growth expected to be adversely impacted

The fiscal costs of generous tax credits granted since 2020 are now reflected in past deficit figures, with the cumulative deficit revision accounting for around EUR 80bn, or 4.5% of GDP over 2020-22. The pure change in the accounting recognition of already assigned tax credits has no material impact on public finances and debt dynamics. The public debt figure is unchanged (in fact, it was slightly revised down to 144.7% of GDP for 2022), while the increase in past deficits reflects the cumulative cost of the measure that would have been accounted for in future years.

Still, the material revision of Italy’s fiscal deficit is relevant for the fiscal outlook and investors’ confidence in Italy’s public finances, particularly as the Italian Treasury will increasingly rely on private investors.

These material revisions cast doubt on the fiscal prudence of past policymakers introducing tax credits without a full understanding of their impact on government finances and the economy. Still, the government’s decision to stop the transferability of tax credits highlights its commitment to take unpopular decisions to safeguard public finances and maintain credibility with investors. In addition, the enhanced clarity of the accounting treatment of tax credits coupled with the likely re-introduction of EU fiscal rules next year provides a firm anchor for Italy’s public finances, reducing the risk of similar costly policies being implemented in the future.

However, the outlook on economic growth, which is critical for Italy’s debt sustainability, may now be adversely affected. ISTAT has also revised its outlook, albeit to a far lesser extent, to 3.7% in 2022 (down from 3.9%) and to 7.0% in 2021 (up from 6.7%).

The government’s decision may in fact contribute to slower activity in the construction sector, as the sudden stop to the transferability of tax credits will not only reduce access to the bonuses but may also challenge the resolution of accumulated stranded credits estimated at about EUR 15-EUR 20bn, exacerbating liquidity pressures in the construction sector. An increase in public investment projects under the NGEU-sponsored National Recovery Plan may only partially mitigate risks for the sector’s outlook.

Finally, the expected reduction in the use of the tax credits could help reverse some of the economic distortions since their introduction, although only at the expense of economic growth.

The widespread use of the bonuses significantly increased construction activity and raw material prices, exacerbating the inflation shock, in turn increasing the cost to the government to EUR 110bn, about 50% above the originally estimated EUR 72bn. The negative side-effects from the tax credits may now be gradually reversed. Still, while inflation pressures may thus ease further, economic growth may be ultimately impacted negatively.