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Rome, July 25, 2013: "If one asks why Italy is a country uncompetitive, I answer because the black economy is so important quantitatively. It distorts competition and creates inefficiency," said Prime Minister Enrico Letta during his speech at the Inland Revenue Office, the day after the government received the vote of confidence from Camera dei Deputati on the Decree Law Fare.

According to the Annual Report Istat, 2012, operating in irregular conditions causes less competitive pressure on companies with a weak stimulation for innovation, investment and improvement of organizational factors. The result is a modest boost to productivity growth, particularly relevant in sectors characterized by a high presence of black economy.

A research by Confcommercio argues that the black economy subtracts more than 270 billion to the Italian GDP. The black economy is equal to 17.4% of the gross domestic product (GDP) in 2012-2013. The black economy in Italy is higher than in most advanced economies. In Mexico this is 11.9%, Spain 9.5%, UK 6.7%, U.S. 5.3%, in Sweden and Austria 4.7%, France 3.9%, Ireland 3.3%, Belgium 2.7%, Canada 2.2%, and in Denmark 1.9%. In Australia, The Netherlands and Norway the black economy is under 1% of GDP.

The Confcommercio report explains that the black economy (or tax evasion) almost makes any policy action for the revival of the production system futile. It is as if two economies live together. The black economy condemns the emerged and perfectly legal economy to constantly lackluster performance, whatever the intensity of policy's pulses is.

The study by Confcommercio talks about hidden economy and tax evasion as if these are synonyms. In reality, in the more strict sense of the two words, these are two different things.

Tax evasion is the illegal evasion of taxes by individuals, corporations and trusts. Tax evasion often entails taxpayers deliberately misrepresenting the true state of their affairs to the tax authorities to reduce their tax liability and includes dishonest tax reporting, such as declaring less income, profits or gains than the amounts actually earned or overstating deductions.

The black economy is a set of all economic activities and transactions that fall outside the official surveys of national accounts, the measurement of gross domestic product and the tax laws of a country. The black economy is also known as "parallel economy" or "hidden economy".

The black economy is a wider concept that includes that of tax evasion. The black economy includes two categories: legal economic activity not declared to the tax authorities and the illegal economic activities. The first category includes black market transactions, retail sales without receipts, services provided without issuing invoices, irregular employment (so-called "moonlighting"), a second job etc. According to a study by Istat in 2010, the percentage of irregular subordinate employment was 11.1%. The failure to disclose the taxpayer to the inland revenue determines the tax evasion phenomenon. The second category includes illegal gambling, selling drugs, racketeering etc.

''The fight against tax evasion must be prioritized to recover resources for employment and growth. And the fight against tax evasion to be effective needs to address any and all determinants together,'' says the study by Confcommercio whose central theme is the explanation of the rate of undeclared income in relation to four major economic determinants:

  1. The effectiveness and efficiency of controls and sanctions: An improvement in the effectiveness and efficiency of the judicial system, which is then reflected on the system of checks and tax penalties, would significantly reduce the rate of hidden economy - the study shows that in response to a 10% improvement in the effectiveness and efficiency of the judicial system, the black economy would be reduced with a percentage of 6.4% (for example, in the Italian case, from 17.4% to 16.3%, with a reduction of just 6.4%).
  2. The perception of the quantity and quality of public services: The study assumed that the tax compliance of citizens depends on spontaneous positive perception of citizens about the quality of services provided by the public administration. Because of the fact that the black economy is not only a phenomenon purely economic, but also social and behavioral. In Italy the perception of efficiency and effectiveness of the public output by citizens and enterprises has remained essentially unchanged since 2000 and even worse in the last year, leaving Italy in the penultimate place in the ranking of the 26 European and non-European countries. According to the study, Italy is among the worst of this ranking in 2011, surpassed only by Mexico and preceded by less developed economies such as those of Greece and Slovak Republic.
    As said in a previous article, the pressure of taxation in Italy is one of the highest in the EU, but the services provided by the public administration are nothing special. The Scandinavian countries, for example, are the most over-taxed ones in Europe, but the quality level of their services is very high.
  3. The cost of the tax liability: The fulfilment of the tax liability is expensive in Italy. This means that in Italy the fraction of the costs incurred by businesses and citizens paying one euro of tax is much higher than in other countries. This is the reason why the taxpayers tend to hide taxable income in order to reduce the generalized cost of their tax liability.
  4. The absolute dimension of the fiscal demand: The higher the tax burden, the higher the convenience to evade. "In Italy the taxes are too high because not everybody pays them," said the President of the Council, Enrico Letta, in his speech to the agency revenue. Letta also said "Commitment to use all the money will come from the fight against tax evasion to lower the tax burden."
    The report on the black economy from Confcommercio also estimated that the observed inland revenue this year is 54% of the emerged GDP.

''The Italians who took their money abroad need to know that the climate has changed and that the international situation does not allow anymore to have the same coverage they had so far,'' Enrico Letta also said. The Prime Minister referred to the tax package that will be approved by the Heads of State and Government at the G20 to be held in St. Petersburg early September. The tax package covers a plan with 15 measures that the OECD has proposed to the G20 countries. This to combat evasion and practice of multinationals to circumvent tax rules denouncing their profits in countries where taxes are less severe. The OECD will translate this plan into rules and standards that harmonize the various tax laws and prevent multinationals to export huge amounts of capital in tax havens bypassing national systems. Then Governments will have to apply the new rules. It will also be possible to set up an automatic exchange of fiscal information.

Minister Fabrizio Saccomanni said that the international cooperation between countries will help to fight against the phenomenon of the black economy: "...years ago, Italy was isolated, but today there is a substantial identity of views in the G20."

''We annually recover 2 to 3 billion more than planned in the budget. This year we are perfectly in line with the trend of last year, so the result at year end may be 12 to 13 billion,'' said the Director of the Italian Inland Revenue Office, Attilio Befera.

A way to find the necessary resources to be allocated for growth and employment is collecting money from tax evasion. From 2000 to 2012, there is still a net amount of EUR 417.5 billion that has to be collected from the taxpayers thanks to the fight against tax evasion. If Italian administration can recover about 12-13 billion euros from tax evasion every year, it will take more than 30 years (equal to 6 legislatures without any political crisis...) before everything has been collected. Without taking into consideration that amount will increase the black economy yearly. Of course this is an implausible hypothesis, but it just gives an idea about the high influence that the black economy has which corresponds with a significant loss of tax revenue and social security contributions.

The reduction in the tax burden (if the tax burden was not seen by the government as a dependent variable of tax evasion, but rather as a determinant of the black economy) would be a powerful catalyst to contrast the black economy and to reposition the competitiveness of the Italian economy.

Investment Implications

iShares MSCI Italy Capped ETF (NYSEARCA:EWI):

It performed well last month, up 9.92% (S&P 500, up 5:39%), last 13 weeks EWI 3.49 (S&P 500 7:33); 1 year performance EWI: 31.31 (S&P 500 26.48). 3 years performance EWI -11.45 (+59.09 S&P 500). The data show that investors are reinvesting in the Italian shares after they had been abandoned for fears about the economic situation of the country.

The basket contains trusted multinational companies such as:

  • oil and gas multinational ENI (NYSE:E), ENEL (OTCPK:ENLAY). They pay relevant dividends to the Italian Treasury. News have been spread recently that the Italian State may sell stakes in ENI and ENEL to help reduce the national debt.
  • Fiat, although recently the company of Torino city is not doing very well due to crisis in the car industry in which it operates.
  • Luxottica that in the second quarter of 2013 showed relevant net profit rises.

I would recommend investing in this basket that contains trusted, important and big Italian companies that operate worldwide.

PowerShares DB Italian Treas Bond ETN (NYSEARCA:ITLY):

Here the situation is more complicated because the investment decision depends on the perception that one has of the risk and if he (she) is willing to take, of course. Investing in Italian State securities is now more than ever for very brave and adventurous investors. For those who took the risk of investing in securities of the Italian public debt in November-December of 2012, before the ECB's announcement about the activation of the OTM and EU's closure of procedure for excessive deficit against Italy, they may enjoy extraordinary returns.

Otherwise I would not recommend a person to invest in Italian bonds now. Instead I would wait to see how the situation evolves in the coming months. The situation in Italy is still serious and very uncertain. Its fundamentals are not good, the country must emerge from the recession and structural reforms it needs to survive.

The country's hope is setting on the Italian politicians. It depends on how long this government will be able to maintain and if it will succeed to implement structural reforms. Meanwhile it is spreading a climate of mistrust.

Structural reforms and fight against the black economy (or tax evasion), if done successfully, will help make the country become more stable and trusted internationally. There will be then positive consequences for Italian securities. The equities of Italian companies will be appreciated even more and the investment in the Italian State securities will be much less risky with consequences in terms of prices and yields, of course.

Source: The Italian Government Declares War On Tax Evasion