Welfare legislation in Italy: the interplay of notional defined contribution pensions and dualism in the labor market

ottobre 18, 2011

Pubblicato In: Convegni

The welfare legislation played an important role in Italian political and economical life. The unforeseen consequences of the generous welfare legislation of the ’70 are the main reason of our huge national debt; attempts to reform met resistance, and in the process, governments fell, alliances were formed and broken. I will focus mainly on the last 17 years, i.e. from the first Berlusconi government, but a few words need to be spent in order to understand the reason for his victory and the dramatic change it represented in the political scene.

After the war, the Communist party, per se not very large, but respected for the role it had in the resistance to the nazi, strong and influential especially in the North, was prevented from getting control of the country because, according to the Yalta pact, the whole of Italy had to remain part of the western block. The constitution of 1948 is the result of a compromise between the communist, the Christian democrats, and the heirs of the lay parties of the pre-fascist era. This compromise eventually developed into a sort of unwritten agreement: the communist would not be part of the government, but they would be guaranteed not to be outlawed as in Germany, and have a say, albeit informal, in the day by day legislation. At the height of its success the communist party got more than 30% of the votes, but never became part of a majority. As a consequence, the space for the “legal” opposition was reduced to 20%, and in order to obtain the absolute majority in Parliament, one had to assemble a coalition representing 70% of the “legal” votes. This resulted in the well known instability of Italian governments; and provided an incentive to yield to populist pressures in the hope to take the wind out of the sails of the Communist party and reduce its influence. The end result was a legislation prone to extend the rights and to be profligate in benefits. The example of the first is the Statute of the workers, of 1970; of the second, the concession of very generous pension benefits, a vastly increased number of eligible people and a low, in some cases ridiculously low, retirement age.

Being part of the coalition gave the “right” to participate in the appointment of areas of economic interest: this provided an incentive to make the area of the economy intermediated by the state more powerful, generous and large: it reached 50%, the largest proportion for a non communist state. Eventually, the corruption became so widespread, visible and arrogant, that it brought the whole system to an end. A very large number of politicians, including former Prime Ministers, were indicted, some arrested, and the political parties that had governed Italy for almost half a century collapsed: the former Communist Party, who after the defeat of the communism, had changed its charter and become PDS (Democratic Party of the Left) was the only to remain more or less untouched by the scandals, because it had been kept aside of the most important and lucrative affairs, whilst enjoying ideological connections with an influential part of the judiciary.

Enter Silvio Berlusconi. Originally a successful entrepreneur in constructions, he became a tycoon with commercial television. Thanks to the political support of Bettino Craxi, Craxi, the socialdemocratic and ferociously anti-communist leader and Prime Minister, he managed to make his Mediaset TV company become a successful competitor to the state owned RAI

monopoly: therefore he can be credited to have broken the state monopoly in TV. By “state” we mean the political parties, which de facto “own” RAI, strictly occupying all the levels of their zone of influence, having passed a legislation aimed ati making it a public and perennial monopoly. Berlusconi feared that, had the coalition assembled by the left won the elections, as everybody took for granted, it would have destroyed his television empire. In order to protect it, and betting on the fact that the majority of Italians would not want to be ruled by former Communists, he founded a new party, ran and won.

It was the first and only Government, with the first and only program, explicitly pro-market since 1876, when the “Historical Right”, which had united Italy, was ousted by an heterogeneous coalition. With the naïveté of the neophytes, Berlusconi’s Government attacked head on the pension system, with a bill that Mrs Thatcher might have considered with favor. But Berlusconi neither was Mrs Thatcher nor had beginner’s luck. Mr. Scalfaro, the President of the Republic, warned that he would not sign a law that would impair the “acquired rights”. Berlusconi’s most important ally got scared and defected, and he had to resign. Mr. Dini, his former Treasury Minister, became the new Premier, supported by a center left coalition. Funny enough, the pension reform that was fatal to Berlusconi, had the signature of Mr. Dini himself, then Treasury Minister. He modified it and got it approved, skillfully maneuvering as not to impair the “acquired rights”, whose protection had been instrumental in ousting Mr. Berlusconi. He did it by introducing long transition periods before the most controversial changes become applicable. But altogether it is a very remarkable achievement, doubtless the most remarkable of his short lived Government. The new law completely redesigns the architecture of the Italian social security system. It is still a pay as you go system: but the defined benefit principle is abandoned in favor of a notional defined contribution (NDC) scheme. Seniority pensions are eliminated – albeit over a long transition period – , additional norms are introduced to complete the harmonization process across regimes and to provide fiscal incentives for individuals to invest in the private pension funds.

Let us look more in detail. With the shift to a notionally defined contribution scheme, the Italian social security system remains unfunded – as current retirees’ pensions were financed by current workers’ contributions – yet, individuals’ pension benefits become directly linked to their lifetime contributions to the system. Indeed, this contributive aspect is only figurative: it works as if every worker had a personal fund where her contributions – corresponding to 33% of her annual earnings – were accrued during her working career. These contributions are capitalized at an interest rate, which is computed as a five years moving average of the nominal GDP growth. At retirement, the accumulated asset value is transformed into an annuity through a conversion coefficient, which decreases with the expected longevity at retirement and increases with the retirement age.
The application of the NDC scheme is pro rata for workers with less than 18 years of contributions in 1995; while workers with higher seniority remain under the previous regime.

The Dini reform also revises substantially the eligibility criteria. Seniority (i.e. early retirement) pensions, whose eligibility was based only on reaching a minimum contribution period, were abolished. Under the private employees’ scheme, the minimum number of years of contribution to be eligible for a pension is reduced to 5 years only; however, only individuals aged between 57 and 65 years are entitled to a pension. These measures have partially reduced the incentives to retire early, since pension benefits depend on retirement age through the actuarial adjustment factor included in the pension benefit’s conversion coefficient. However, Italian pensioners are completely insulated from the underlying labor market conditions. After retiring, pensions are kept constant in real terms, independent of wage growth.

Mr Dini skillfully resolved the conundrum by moving in the future the day of implementation of the new system: ten years for reviewing the pension age according to the extended life expectancy; 18 years for fully implementing the new calculation method; exemption for specially hard works to be defined. But the structure of the law is still considered to be among the best in Europe.

There have been successive changes in details: one brought about by Mr Prodi, the premier of the center left Government that succeeded to Mr. Berlusconi from 1996 to 2001, extending the pension law also to the employees of the public sector; another during the second Berlusconi government, from 2001 to 2006, trying to shorten the transition period. The first succeeded, the second was repealed by the following short Prodi II government, 2006 to 2008. In the last weeks, proposals to postpone the retirement age ignited bitter political controversy.. The weakness of the Berlusconi government has grown to such an extent, he did not use to our advantage the caveats of the ECB and the pressure of the financial markets, not even to get the most obvious reform approved, i.e. the same retirement age for men and women alike.

Today those who can retire at the end of a regular working life are relatively lucky. The problem are the others, the jobless, those who have been laid off, those who never got a job. In some areas of the country, obviously the South, and for some age brackets, the percentage of unemployed exceeds 30%. And we are speaking of men, because women often don’t even look for a job. And so we come to the other aspect of the welfare system, i.e. the labour legislation, more specifically the protection in case of loss of work.

What the legislator had in mind, when drafting the labor charter of 1970, was a stable economy, overwhelmingly dedicated to manufacturing, not exposed to external shocks, be it from technology or trading pattern; where people enter young in the job market, preferably in a large firm, capturing most of the gains from the increase in productivity, and retire early with a pension with a substantial replacement rate, replaced by an increasing number of new workers who earn an even larger salary. In this vision there is no need for unemployment assurance, and Italy has none: instead it has a stringent law making firing of workers extremely costly and risky for the firm. In case of temporary problems of the firm, the workers receive a subsidy from an insurance funded by contributions paid mainly by the all the firms collectively. In case of permanent problems, – downsizing, change of production, definitive closure – a special insurance paid by the state lasts 18 months during which worker’s unions and industry associations engage in long discussions. Sometimes the benefit is extended beyond its normal term, at the expense of the taxpayer.

The rigidity of the labor legislation, in particular the constraints imposed on the exit, have a direct correlation with the structure of the labor market, and on the pension at retirement. The structure of the manufacturing industries has evolved towards a world very different from the stable and secure one, which had been the cultural and political model for the socialdemocratic authors of the Statute of the Workers. Introducing flexibility in this rigid framework became soon a question of survival. However the flexibility was only “at the margin”, that is, for new hires. Italy experienced a large increase in the number of fixed-term contracts, their share on total dependent employment rapidly approaching two-digit levels from scratch.

This dualism involves a significant wage discount of temporary vs. open-ended contracts. This discount is imposed due to the stronger bargaining power of regular workers (insiders) vis-à-vis workers with flexible contracts and to the lower outside option of the latter (outsiders). Due to eligibility rules to unemployment insurance requiring some minimum contributory record, most workers with flexible contracts do not have access to unemployment benefits in case of job loss. The dualism outsiders vs insiders is likely to prolong itself beyond the working life, affecting the future pension entitlements of the youngsters. This is because of several reasons: first, because workers with temporary contracts earn, coeteris paribus, less than workers on open-ended contracts; second, because they experience more frequent career breaks due to the fact that job shedding is concentrated on temporary contracts (as clearly indicated by the Great Recession), and third because during unemployment spells, they are generally not covered by unemployment insurance.

This problem of adequacy is not directly related to the design of the NDC itself, but rather to the dualism of labor markets. Thus, solutions should be found by addressing directly this problem. Art 18 of the Statute of the Workers, which make firing of a worker unlawful except in the most extreme cases, has become a symbol: on one side the unions, backed by the left including a sizable part of Catholic politicians, defending it as a non negotiable right, on the other the reformers fighting for its abolition as a non tolerable hindering. It has been a long political battle, in which I was personally very much involved: I presented a bill where the abolition of the “job property” principle was compounded by a much more effective system of protection, increasing with age at work and with anagraphical age. It was definitely favorable for the workers, and this might explain why it was only halfheartedly accepted by the industrial association. I wrote articles, organized conferences, promoted a book (“It is not enough to say no”) with the contributes of influential scholars of the left and some entrepreneurs. The fact that I had been elected with the votes of the left, raised many eyebrows, and elicited some harsh comments.

In any case I was reelected in 2001, the center right government proposed to abolish art.18. but did not dare to fight the unions head on. The proposal was watered down, then reduced to a temporary experiment, and finally dropped. The stronghold of art 18 being seemingly unconquerable, in 2010 it was tried to circumvent it: keep it as general provision at national level, but allow individual agreements to suspend it at firm level. Obviously it is not the same thing, but even in this reduced form it encountered heavy fire, in form of general strikes.

The dualism in the labor market of many European countries may interact with the existence of an NDC pension system, which strongly ties pension benefits to previous contributions.

To highlight the concern about the long term effect that discontinuous working careers have on future pension benefits, let us consider the case of three (male) individual with different career pattern. The first one, let us call him Albert, enters the labor market at age 25 and holds a temporary job until age 28; he then remains unemployed until he turns 29, when he finds a fixed term job, which he holds until he is 32, when he becomes unemployed again for one year. At age 33, he obtains a fixed term job, which he holds for two years, until he finally gets a permanent job until retirement. The second one, Bill, enters the labor market at age 25 with the same wage as Albert but enjoys an uninterrupted career with permanent jobs only. And then Charlie, who also enjoys a uninterrupted career with permanent, enters the labor market at the same age of 25 but with an initial wage 25% higher than Bill’s.

Albert, Bill and Charlie all have upper secondary education, the wage profile for all of them is taken from the tables of the European Household panel, expressed in 2001 €. As highlighted above, workers with temporary contracts earn, all other things being equal, less than workers on open-ended contracts. Even if he eventually will catch up, he cannot rely on the beneficial compounding capitalization on the very early contributions, due to his discontinuous working career.

Under certain (optimistic) assumptions on the growth rate in Italy, if Albert retires at 60 his monthly pension benefit will be around €650 with a replacement rate around 50%. Albert will thus be induced by the low pension benefit to postpone retirement: only at 67 years, will Albert obtain a more sizable pension benefit around €1000.

Bill enjoys not only a higher wage at the end of his working life, but also benefits from early career contributions. If he retires at 60, his monthly pension will be around €850, almost a third higher than Albert’s. By retiring at 67, his pension would be €1280, with a replacement rate between 75% and 84%.

Finally, Charlie, who entered the labor market with a permanent contract, and with a 25% higher initial wage, will obviously enjoy a much higher wage at the end, €2000. Retiring at 60, he enjoys a pension benefit around €1100, although a replacement rate of 55%. But postponing retirement until 67 would lead to sizable pension increments, with benefits between €1513 and €1677.

The dual labor market notoriously has a strong, negative effect of the current young generation. These simulations suggest that it will continue to take its toll even in the long run, as pension benefits and replacement rates will be much lower than today. This means that troubles may be lying ahead for the NDC system, not because of some intrinsic feature of the system, but rather from its interaction with the dual labor market.

So where do we go from here? Italy has world’s third largest public debt, and exhibits practically no growth since at least 10 years. It faces therefore a double challenge, to have a growth rate higher than interest rates, and to control public expenditure so that it can maintain a net surplus before interest, and this for many (20?) years to come. The political situation is at present rather confused, and it is not easy to foresee when we will have new elections, in 201 or in 2013, and who will win, a centre right or a center left coalition. The constraints are the same for both, for the moment neither of the two seem to have a solution in mind.

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