US embassy cable - 04ROME4599

UNCLAS  ROME 004599 
 
SIPDIS 
 
 
C O R R E C T E D  C O P Y (PARAGRAPHS 4 & 5) 
 
DEPT FOR EUR/WE, EUR/ERA, EB/IFB/OMA 
PARIS ALSO FOR USOECD 
 
TREAS FOR OASIA HARLOW, STUART 
STATE PASS CEA 
STATE PASS FRB FOR GUST 
FRANKFURT FOR WALLAR 
USDOC 4212/ITA/MAC/OEURA/CPD/DDEFALCO 
 
E.O. 12958:  N/A 
TAGS: ECON, EFIN, ELAB, PGOV, IT, KPRP 
SUBJECT: ITALY'S UNDERGROUND ECONOMY 
 
REF:  A) 2003 Rome 2846, B) 2003 Rome 579, C) 2003 Rome 294 
 
 
SUMMARY 
------- 
 
1.  The underground economy has been a consistent part of 
post-war Italy, and is a result of the country's systemic 
inefficiencies, in particular its bureaucracy, high 
taxation, and rigid labor market.  Recent estimates place 
the size of the underground economy at about 15-17 percent 
of Italian GDP, or some 190-204 billion euro in 2002. 
While it is part of the economy in all sectors and all 
regions of the country, the underground economy is most 
prevalent in agriculture and in southern Italy, 
historically less developed and economically less advanced 
than the wealthier north.  Consequences of this large 
underground economy include diminished tax revenues for the 
government and an unfavorable business climate, which has 
affected foreign investment throughout the country, 
especially in the south. 
 
2.  There have been many attempts to regularize underground 
businesses, but these programs have been largely 
ineffective.  The Berlusconi government has expressed a 
renewed interest in "regularization programs;" and the EU, 
through the Stability and Growth Pact, has also increased 
pressure on the GOI to put forth a coherent, effective 
policy to combat the underground economy.  Italy's need to 
keep the budget deficit/GDP ratio under the three-percent 
ceiling as a condition of its membership in euro zone 
Stability and Growth Pact may finally provide the incentive 
for increased government action, as the possibility of 
levying taxes on the very large underground economy might 
represent too large a source of potential government 
revenue to ignore.  End Summary. 
 
INTRODUCTION 
------------ 
 
3.  Italy's underground economy is second in size only to 
Greece's in the EU-25, but the size varies greatly from 
sector to sector and by geographic region.  ISTAT, the 
National Statistical Institute, estimates the underground 
economy nation-wide as a percentage of reported GDP at some 
15.1-16.2 percent.  This figure, however, is misleading in 
that the southern regional average is more than 2.5 times 
the northern average.  Lombardy (the region where Milan is 
located) has the smallest underground economy/gross 
regional product ratio at 8.9 percent, while the 
underground economy/GRP ratio of Calabria (the "toe" of the 
boot in the extreme south) reaches a startling 30.0 
percent.  Campania and Sicily both have respective ratios 
of 25.1 and 25.0 percent, according to ISTAT. 
 
(Note: not surprisingly, these regions lead the nation in 
official unemployment.  Sicily features a 17.4 percent 
unemployment rate; Campania, 15.5 percent; and Calabria, 
14.9 percent.  These high rates, which become even higher 
when divided into specific groups (namely teens, women, 
retirees), can partially be explained by a large, 
widespread underground economy, which lowers the real level 
of unemployment. End note.) 
 
UNDERGROUND ECONOMY AND THE STABILITY AND GROWTH PACT 
--------------------------------------------- -------- 
 
4.  The EU has officially estimated the Italian underground 
economy at 17.0 percent of GDP.  Further research suggests 
a theoretical annual loss of tax revenue equal to 85 
billion euro (108 billion UDS). Censis, a Rome based think 
tank, notes that recouping only five percent of this figure 
would bring the GOI almose 4.3 billion euro in new annual 
revenue. Our censis contact noted that since the GOI is 
having difficulty keeping the budget deficit/gdp ratio 
under the three percent stability and growth pact ceiling, 
this increase in gdp would increase the absolute deficit. 
Italy could still run and still remain with pact limits. 
 
5. Comment: As PM Berlusconi continues to push for tax 
 
cuts, he will be searching for extra funds that make these 
cuts feasible while keeping Italy's deficit/GDP ratio under 
three percent.  This may increase GOI efforts to recoup 
revenues lost to the underground economy.  The 2005 budget 
bill under consideration in Parliament already includes 
measures to strengthen tax collection and targets rental 
income and earnings of the self-employed.  End comment. 
 
IMPLICATIONS FOR FOREIGN INVESTMENT 
----------------------------------- 
 
6.  The Economist Intelligence Unit ranked Italy as 
thirteenth among fourteen western European nations in terms 
of attracting foreign investment between 1995 and 1999, and 
the ranking is not expected to change for 2000 through 
2004.  Put another way, Italy has an economy similar in 
size to that of Britain yet attracts far less foreign 
investment.  The same report cited excessive bureaucracy, 
high payroll costs, and rigid labor laws as reasons for 
this disparity. Furthermore, a recent World Economic Forum 
report ranked Italy 47th in the world in terms of 
"competitive environment" (down six places from 2003 and 21 
places from 2001).  The World Economic Forum cites Italy's 
lack of research and development as one major factor for 
this low ranking; but taxation, red tape, and lack of 
infrastructure were also factors.  These larger structural 
problems of the Italian economy - in particular, taxation 
and red tape - are reasons firms and people move their 
transactions to the underground economy.  Further, the 
extent of the large underground economy contributes to a 
lack of transparency and affects the overall business 
climate.  An unfavorable business climate further 
discourages investment, and begins the cycle once again. 
 
COUNTERFEITING AND THE UNDERGROUND ECONOMY 
------------------------------------------ 
 
7.  One popular stereotype of the Italian underground 
economy is that of non-native Italians selling counterfeit 
sunglasses, handbags, or CDs in front of architectural 
treasures.  While this type of one-person street market is 
increasingly widespread and visible, the phenomenon 
actually represents a minor part of the black economy.  The 
largest part of underground transactions is otherwise legal 
activities (hiring undocumented domestic help, sales at 
legitimate shops without receipts) that are illegal only 
because they are unreported. 
 
8.  Nevertheless, Italy has become a major European hub for 
counterfeit goods either arriving from East Asia or 
produced within the borders of Italy.  This has had a 
deleterious effect on American business, in particular 
trademark and copyright industries, but has had an even 
larger impact on the Italian economy.  Specifically, 
specialty goods play an important role in the Italian 
economy, with fashion, food products, and artisan 
production providing much of Italian exports; 
counterfeiting has disproportionately plagued these three 
sectors.  A contact at the Finance Ministry offered the 
example of textiles: a recent GOI investigation found large 
quantities of Chinese textiles coming through the port of 
Naples undervalued for tax purposes.  After the textiles 
pass through the port, they are marked up on the market to 
a price that still undercuts Italian products.  This is 
doubly harmful, damaging the domestic textile industry and 
raising the possibility of organized crime involvement, as 
the destination of the large profits remains unknown. 
 
9.  Piracy and counterfeit goods have increasingly been 
linked to organized crime.  In 1999, a high-profile arrest 
of fourteen members of the Camorra (a Naples-based 
organized crime syndicate) for participation in an 
international piracy ring stretching from Italy to Russia 
to Southeast Asia highlighted the role of organized crime 
in piracy.  A former Camorra member testified that the 
organization earned around 100,000 euro weekly from drugs, 
extortion, and the manufacture and distribution of pirated 
music.  Some observers question whether, as counterfeiting 
in Italy becomes more "globalized," featuring players from 
throughout the world, large profits from piracy on the 
 
Italian underground economy could be a source for terrorist 
funding. 
 
10.  Italian law enforcement agencies, especially the 
Financial Police (Guardia di Finanza), have been far from 
passive in the face of this onslaught of counterfeiting. 
The Guardia recently released a report on anti- 
counterfeiting operations in the first six months of 2004. 
The report notes that the 20,000 investigations performed 
in Italy rank second in number only to Belgium.  In this 
same period, the Guardia and Customs officials seized 8.8 
million pieces of counterfeit goods, with an estimated 
value of three to seven billion euro.  Thirty percent of 
all seizures of pirated goods in Europe reportedly occur in 
Italy. 
 
11.  Despite these successes, the anti-piracy campaign 
remains an uphill battle.  Municipal police officers 
routinely ignore the wide-open street vending of 
counterfeit products, and there have been complaints that 
Italian officials are not truly behind efforts to control 
piracy.  Even when law enforcement officials have taken 
action against counterfeiters, magistrates often mete out 
minimal punishment for piracy.  Consulate Florence, for 
example, reports a recent episode in which a prosecutor 
asked a city police officer, who presented him with a 
report on a seizure of counterfeited items, "are you still 
going after these things to please a few rich merchants in 
the downtown area?"  In addition, delays in the judicial 
process often lead to the expiration of statutes of 
limitation, further rendering futile police efforts against 
counterfeiting. 
 
REASONS FOR THE UNDERGROUND ECONOMY 
---------------------------------- 
 
12.  Experts on Italy's underground economy have attributed 
its large size to high payroll taxes and payroll benefit 
contributions, rigid labor laws, immigration, and history 
and culture. 
 
13.  Taxation and Benefit Contributions.  Italy has some of 
the highest taxes and fiscal contributions in Europe. 
Salvatore Tutino, Director of SECIT (a think-tank 
associated with the Ministry of Finance), gave the 
following example to illustrate the problem: a worker 
earning a salary of 100 euros will take home 60 euros, 
while the employer who pays a salary of 100 euros will 
really pay 140 euros due to payroll contributions (i.e., 
social security).  It is then often in the interests of 
both parties to circumvent the laws (through "double pay" 
(one lower official salary, supplemented with unreported 
cash to reach the real salary), part-time contracts, 
complete evasion).  Experts have also noted that when a 
business encounters any financial problems, usually the 
first action taken is to evade taxes to save money.  This, 
in turn, forces the government to raise taxes on those who 
pay, in order to make up for revenue loss due to the 
underground economy.  Moreover, underground labor 
artificially raises the number of unemployed eligible to 
receive welfare benefits (unemployment, housing and 
education subsidies, etc.), further increasing goverment 
costs; higher taxes then lead to increased pareticipation to 
the underground economy, and s/ the vicious cycle 
continues. 
 
14.  Rigid Labor Law.  The Berlusconi government has made 
relaxing labor laws one of the central tenets of its 
platform (Ref B). Labor laws passed in the context of 
labor in heary industry and large social in the 
1960's and 70's have undermined the viability of small and 
medium sized firms in recent years. Article 18, for 
example, a labor law that recently caused great controversy 
(Refs A, C), requires employers to provide employees a 
whole set of rights and benefits in firms with 15 or more 
employees. Business. in response, use different methods 
to maintain fewer than fifteen workers on the books, even 
when they employ many more.  A firm, for example, could be 
divided into two (on the record), or businesses could hire 
undocumented labor to remain below the threshold.  Article 
 
 
18 makes it nearly impossible for the owner of a medium-to- 
large-sized business to dismiss employees.  This inability 
to fire workers makes the use of undocumented labor highly 
attractive. 
 
15.  Immigration.  Analysts believe the vast majority of 
the more than three million estimated participants in the 
underground economy are Italian citizens and that 
immigration has contributed only slightly to the 
underground economy.  However, the underground economy does 
offer new arrivals opportunities to work illegally. 
Moreover, despite recent discussions about making obtaining 
citizen status easier, citizenship laws remain strict, 
further encouraging immigrants to remain underground. 
 
16.  History and Culture.  The most persistent and 
difficult aspect of the underground economy to change is 
that related to history and culture, especially in the 
south since the end of the Second World War.  A general 
practice since 1945 has been for heavy industry in the 
north to subcontract work to smaller southern businesses to 
save labor costs.  This arrangement works for both sides, 
as the north reduces its overall labor costs; and the south 
receives much-needed employment opportunities.  This 
arrangement "works" because it circumvents labor contracts 
negotiated by unions that require equal pay for similar 
work regardless of geographic location (a southern worker 
must be paid as much as his northern counterpart).  The 
arrangement costs the government double, however, insofar 
as off-the-books work leads to lost tax revenue and 
increased spending on unemployment.  Despite numerous 
government attempts to regularize such off-the-books work, 
the practice continues.  Professor Luca Meldolesi, the head 
of the National Committee for the Emergence of Labor, notes 
that it will take a massive effort to change cultural 
norms.  He maintains that working legally in some southern 
regions is the exception, not the norm (ISTAT reports that 
in Calabria's agricultural sector, the underground/regional 
product ratio reaches an astounding 53 percent). 
 
17.  A culture of dependence on government unemployment 
assistance in the south also contributes to widespread 
underground employment.  As Francesca Dini, an expert on 
the underground economy at CENSIS, noted, an agricultural 
worker needs to work only one month to receive generous 
unemployment benefits for an entire year.  Often, one will 
work enough to collect benefits, get "laid off," then 
continue to do the same job under the table. 
 
THE EU, ITALY, AND THE UNDERGROUND ECONOMY 
------------------------------------------ 
18.  As noted above, Italy features the second-largest 
underground economy in the EU-25 countries, second only to 
Greece. The Italian government has advocated an increased 
EU role in combating the underground economy to lend GOI 
domestic initiatives greater legitimacy. 
 
19.  On the European level, however, our Italian 
interlocutors tell us that EU efforts to address the 
problems of the underground economy have not amounted to 
much.  A 1998 European Commission Communication tried to 
encourage cooperation and the formulation of joint policies 
to combat the underground economy.  Six years later, it 
appears this effort has not worked; the recent expansion of 
the EU to 25 members may have exacerbated the problem. 
Meldolesi, the head of the National Committee for the 
Emergence of Labor, noted some of the difficulties.  Some 
European nations, he noted, refuse to admit the underground 
economy is a problem.  Competition among nations for jobs 
has been magnified by the EU's recent expansion (as Western 
European nations fear the loss of jobs to new entrant 
nations with cheaper labor costs); as this debate has 
dominated labor discussions, there has been little recent 
discussion regarding the underground economy at the 
European level. 
 
RECENT ITALIAN EFFORTS TO COMBAT THE UNDERGROUND ECONOMY 
--------------------------------------------- ---------- 
 
20.  To its credit, the Berlusconi government has tried 
some new approaches to combat the underground economy, 
although results have been mixed.  Berlusconi's major 
initiative was Law 383 of 2001.  This comprehensive law 
marked a departure from past limited government 
initiatives, which offered blanket amnesties and 
regularizations.  Law 383 provided real incentives for 
regularization of off-the books arrangements, including 
amnesties for past years, schemes for the repayment of past 
taxes, and temporary reductions of labor costs.  The law 
also sought to streamline the regularization process buy 
creating "regularization centers," one-stop sites where the 
process could be completed.  However, this law did not live 
up to expectations; at the end of the amnesty period, only 
1,029 businesses presented regularization plans covering a 
total of 3,854 workers.  Recent government attitudes have 
shifted away from assisting violators to punishing them. 
The government, for example, has recently focused on new, 
previously untargeted areas such as unreported hotel and 
rental income.  The scope of these initiatives remains to 
be seen. 
 
21.  It is too early to draw a firm conclusion regarding 
the success (or failure) of the Berlusconi government's 
efforts to normalize underground economic activity.  The 
most current statistics date from 2002, the year in which 
Law 383 came into effect.  A recent ISTAT report notes an 
overall increase in the size of the underground economy 
between 1992 and 2002 (from 12.9-15.8 percent of GDP in 
1992, to 15.1-16.2 percent in 2002), although the same 
report also notes a slight decrease between 2001 and 2002 
when the economy is broken into sectors. 
 
22.  Experts on the underground economy have all told us 
that successful initiatives must be specific to sectors and 
geographic regions, and that employment costs must be 
lowered.  Some experts, however, believe lowering taxes and 
employment costs alone will not remedy the situation.  The 
phenomenon of the black economy has become so ingrained in 
Italian society that a thorough re-education may be 
necessary.  Such experts say that while past and current 
administrations have issued blanket amnesties to repatriate 
lost taxes, such a solution is only temporary, and thus not 
effective, because it does not change the underlying 
societal norms.  Amnesties, in fact, can be 
counterproductive, in that they encourage further 
illegality, since violators believe they can depend on 
future amnesties to legalize their situation. 
 
23.  That said, there has been a noticeable change in GOI 
efforts to combat the problem of "off-the-books" economic 
activity.  As previously stated, policy focus has shifted 
away from helping violators legalize their status to making 
more permanent societal changes that could lead to a 
systemic correction.  For example, the Berlusconi 
government has established the National Committee for the 
Emergence of Labor, to deal solely with drafting strategies 
to combat the underground economy.  This committee, which 
features representatives from major government ministries 
and institutes, has worked predominately in the south with 
local governments, universities, and other groups dealing 
with the underground economy.  The committee has also 
worked with the Iacocca Institute of Lehigh University 
(Pennsylvania) to set up "field schools" to educate local 
entrepreneurs about business practices as part of the 
effort to change the overall labor culture.  One school has 
been opened in Calabria, and three more are planned. 
 
24.  While experts with whom we met seemed enthusiastic 
about such new approaches to the underground economy, the 
impact of such initiatives remains to be seen.  There was 
similar enthusiasm for the 2001 legislation, but 
disappointing results soon followed.  The head of the 
Committee for the Emergence of Labor, Meldolesi, also 
feared his funding would not be renewed given current 
budget pressures. 
 
COMMENT 
------- 
 
25.  The Italian underground economy is a structural 
problem that the government cannot ignore.  Like so many 
other aspects of Italian society, it is intertwined with 
the larger north-south divide, historical development, 
immigration, and culture.  It is an encouraging sign that 
the Berlusconi government has chosen to address the 
problem, and has proposed new ideas to combat it. 
Meaningful results, however, are not yet apparent, and some 
observers question whether this government will maintain 
the political will to persevere. 
 
26.  External pressures on the Italian economy, however, 
may leave the government no choice.  Tolerating an 
extensive underground economy may become increasingly 
burdensome, and external pressures could spark a real 
effort to change.  Specifically, Italy's obligations under 
the Stability and Growth Pact may make it impossible to 
ignore the potential government revenue lost to the 
underground economy.  In addition, to remain competitive in 
the global economy, Italy must create a more favorable 
business climate to attract higher amounts of foreign 
investment.  Both of these forces make decreasing the size 
of the underground economy more important now than ever. 
 
27.  This message was drafted by Embassy Rome intern Thomas 
Bollati. 
 
 
SEMBLER 
 
 
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 2004ROME04599 - Classification: UNCLASSIFIED