The tightening in financial conditions in the wake of euro area monetary policy tightening has been substantial. Lending rates to households and businesses have increased by around 3 percentage points since mid-2022. Credit growth has turned negative and the housing market has softened. The banking sector is well capitalised and better prepared to withstand shocks than in the past. But the banking and insurance sectors have substantial holdings of sovereign debt, requiring continued monitoring of balance sheet pressures that may arise from higher interest rates or the slowdown in growth.

Fiscal policy is now broadly neutral. Government support related to the energy crisis has partly been withdrawn and should end, but the National Recovery and Resilience Plan (NRRP) and targeted income tax cuts are supporting demand. If energy prices were to rise significantly again, only measures targeted to poor households should be re-introduced. With public debt high and on an upward trajectory under unchanged policy, the public finances will need to be consolidated.

OECD projections envisage subdued economic growth in 2024-25. Inflation is expected to decline gradually, as the energy price shock has led to wider price pressures that will take time to dissipate. Risks are tilted to the downside and tighter-than-expected financial conditions would further reduce domestic demand. On the upside, the faster spending of NRRP funds, including by re-focusing the Plan on large and centrally managed investment projects, as planned by the authorities and endorsed by the European Commission, could boost investment.

Public debt is among the highest in the OECD as a share of GDP. With substantial fiscal pressures on the horizon, tax and spending reforms are needed to help put debt on a more prudent path.

The public debt to GDP ratio is on an upward trajectory under unchanged policies. Public expenditure on ageing-related costs and debt servicing costs are expected to increase by about 4½ percent of GDP between 2023 and 2040. Additional spending pressures are likely to arise from accelerating the climate transition and adapting to climate change. A sustained fiscal adjustment will be required over a number of years to put the debt ratio on a more prudent path, meet future costs and comply with proposed EU fiscal rules.

There is a need to make savings in government spending. Pensions account for a heavy share of overall spending. In the near term, this could be contained by phasing out early retirement schemes. The partial de-indexation of high pensions should be maintained in the near term but replaced in the medium term with a tax on high pensions that are unrelated to past pension contributions. This solidarity contribution of current pensioners could be maintained until the relative income of pensioners becomes more closely aligned with the OECD average. The forthcoming spending reviews – which currently target annual fiscal savings of around 0.2% of GDP – need to become more ambitious.

The ongoing tax reform should help address fiscal pressures. Efforts to tackle tax evasion should be continued, including by continuing to promote digital payments and reversing the increase in the ceiling on cash transactions. There is also room to reduce the erosion of the income tax base, including by reducing tax expenditures and limiting the proliferation of special flat tax regimes. Shifting taxes from labour to inheritance and property would make the tax mix more growth-friendly, while allowing revenues to increase. This should include updating the property tax base calculations, while taking into account distributional impacts.

The economy faces challenges from low productivity growth, low labour market participation, especially of women, and relatively high poverty. Transitioning to innovation-led growth, while strengthening inclusiveness, will require a comprehensive package of reforms.

The ongoing civil justice and public administration reforms will be crucial to raise investment and productivity. The long duration of trials and excessive bureaucracy have held back private and public investment. The recent reforms to streamline legal and administrative procedures, raise capacity, and strengthen judges’ and civil servants’ performance incentives should be thoroughly implemented. Strengthening the mobility of public servants would reduce entrenchment in positions with excessive discretion over administrative procedures and thus the risk of corruption.

Remaining regulatory barriers to competition must be lifted, especially in professional services. “Fair compensation” rules for professional services risk being perceived as minimum tariffs, thereby reducing market entry and price competition. Their scope should be reduced. The competition reform legislated in 2022 should be fully implemented, including by submitting concessions to public tenders at expiry.

Labour market participation of young people and women is among the lowest in the OECD. Labour market prospects of young people could be improved by expanding technical tertiary schools (ITS Academy), and female labour market participation could be enhanced by significantly expanding early childhood education and further strengthening incentives for paternity leave.

The government has discontinued the Citizen’s Income and introduced a new social assistance scheme (Adi) and an employment support scheme (Sfl). Work incentives of benefit recipients in the new scheme could be improved through a more gradual withdrawal of benefits in case of taking up employment. Expanding access to the social assistance benefit (Adi) to people with very weak labour market prospects at a reduced rate would ensure that limited funds for training are targeted to employable people, while ensuring that the most vulnerable remain covered by the social safety net.

Strengthening the training system would help bring vulnerable people into the labour market. Lack of skills is a key barrier to employment. The NRRP provides funding for a new lifelong-learning programme that should be complemented with rigorous quality control for training providers. This includes introducing a national-level certification scheme for training providers and the expansion of existing programmes that make payment to training providers conditional on recipients durably finding employment.

The authorities aim for net zero greenhouse gas emissions by 2050. The economy’s low energy intensity and abundant solar resources make Italy well placed to achieve the climate transition. But a further strengthening of existing measures and additional policies are needed to accelerate the reduction of emissions and adapt to climate change.

Significant progress in emissions reduction was made in the wake of the global economic crisis of 2008-09. The pace of emissions reduction has slowed over the past decade as growth has recovered and new policy action has slowed. Reaching the intermediate target of a 55% emissions reduction by 2030 (relative to 1990) will require a significant increase in the pace of emissions reduction. Enshrining the 2050 net-zero target in law and setting up an independent climate council for policy evaluation and advice could help strengthen government accountability.

The expansion of renewable electricity continues to be hampered by complex permitting processes despite recent streamlining. Fully unlocking the potential of renewables will require defining the criteria for the identification of suitable areas for renewable power plants, raising the capacity ceiling for simplified permitting procedures, and swiftly implementing key investments to enhance the transmission grid.

Improving public transport and reducing the number of highly polluting cars would reduce emissions from the transport sector. Transport could be further decarbonised by investing in the railway network, reducing the favourable tax treatment of diesel over gasoline and introducing financial incentives for the scrapping of old cars, irrespective of new car purchases. Electric vehicle (EV) use could be promoted by ramping up the deployment of publicly available electric charging stations, phasing out purchase subsidies for internal combustion engine cars and refocusing support on entry-level EVs, as well as aligning taxes on car sales, registration and ownership to emissions.

Retrofitting Italy's old building stock is crucial to decarbonise. Cost inefficient and regressive schemes that promote investment in energy efficiency renovations have been reformed but may be insufficient to induce retrofitting by low-income households with low tax bills. The current schemes should be complemented with a mix of subsidised long-term loans and grants, while subsidies for the installation of gas-powered boilers should be phased out. Regulatory measures or higher taxes for the rental of energy-inefficient properties would encourage energy efficiency renovations.

Approving the National Climate Adaptation Plan would equip Italy with a coherent adaption framework. Necessary investments are underway and appropriate funding will be key to sustainably mitigate the risk of flooding and landslides.