Is the United States Following Italy’s Lead on Debt?

In recent decades, Italy has provided “responsible countries,” such as the United States, with a convenient example of what not to do in economic and fiscal policy.

Italy has had high fiscal deficits, high and growing public debt — and taxpayers that were recognized as being world champions in tax evading.

In my career as the head of the fiscal affairs department of the International Monetary Fund, I often heard people say that it would be nice to live in Italy because “nobody pays taxes.” The United States was assumed not to have these problems. Americans followed the rule of law faithfully and, unlike the Italians, paid their taxes fully. Additionally, Italy was corrupt. The United States was not.

These views were so prevalent that they were accepted with the same degree of certainty as the statement that the sun rises every morning. Never mind that the Italian nation of tax evaders, who presumably did not pay any taxes, ended up paying about 15% of their GDP more in taxes than the Americans!

Things started to change in the United States in the current decade. News about tax evasion indicated that Italians did not have a monopoly in that activity. Americans had been learning fast, taking advantage of institutions in Switzerland, Lichtenstein, Antigua and other places where individual taxpayers could deposit their money and forget about the taxman.

American companies also learned fast, and the amount of unpaid taxes was soon estimated to have risen in the hundreds of billions of dollars.

Acts of corruption also became daily events in the U.S. media. So were spectacular acts of financial chutzpah and poor oversight. Some of these acts (e.g., Madoff’s) make Italians look like dilettantes.

Finally, the current economic crisis has accelerated the already uncomfortable dynamic of projected future fiscal developments in the United States. It is no longer farfetched to think that, based on current trends, the fiscal situations of the two countries will converge at some not-too-distant date.

Changing these trends will prove more difficult than generally assumed. There are no easy “exit strategies” in the fiscal area.

For evidence, look no further than recent official forecasts for three sets of fiscal data: public spending, general government balance (the fiscal deficit) and public debt.

The objective is to show how much the fiscal situations of the two countries are changing — and how they are expected to change in future years under current policies. The variables relate mostly to general government, which includes local governments.

Between 2007 and 2010, public spending in the United States as a share of GDP is forecast to rise by 6.3 percentage points, the fiscal deficit by 11.4 percentage points and public debt by 28 percentage points. By contrast, in Italy the increases in these variables are forecast to be far more modest — respectively 3.2, 3.2 and 12.0 percentage points. (See the table below for details.)

By next year, 2010, the two countries will become much more similar than they were in 2007 with regard to their public debt and public spending. U.S. fiscal deficits will be much higher.

Unfortunately for the United States, the story does not end here. Expected future developments will accelerate the process of convergence of public debts and public spending of the two countries.

The European Commission recently estimated the expected increase in public spending for Italy to the year 2060 related to pensions, health care and long-term care. As a percentage of GDP, the expected increase for Italy over the 2007-2060 period is only 1.6 percentage points. The increase might be even lower because Italy is contemplating an increase in the retirement age for women to bring it to the same level as that of men.

The European Commission does not provide projections for the United States. However, a July 2009 Congressional Budget Office report and a June 2009 paper by Awerbach and Gale provided broadly comparable projections.

These estimates show that current policies, if not changed, would be consistent, in 2020, with fiscal deficits (for federal and not general government) of 7% of GDP and with public debt of more than 100% of GDP by 2023. The 7% deficit, caused by the increase in public spending, would bring that spending in line with that of Italy.

Thus, by this time Italy and the United States would look like twins in terms of their fiscal accounts. However, public spending and public debt will continue rising in the United States. Under current policies, U.S. public debt is expected to rise to 650% of GDP by 2076.

It seems that in not too many years, Italy and the USA might become fiscal twins. Later, Italy might even become a good example of responsible fiscal policy.

Editor’s Note: This Globalist Retrospective essay was originally published in December 2009.