Fiscal devaluation and relative prices: evidence from the Euro area

International Tax and Public Finance https://doi.org/10.1007/s10797-020-09623-4 Fiscal devaluation and relative prices: evidence from the Euro area Giampaolo Arachi1 · Debora Assisi1 © The Author(s) 2020 Abstract The theoretical literature has long recognized that a fiscal devaluation, brought about by a budget-neutral shift from social security contributions towards value added tax (V-FD), could improve price competitiveness and help restore trade imbalances, especially for countries that cannot devaluate their currency. This paper provides evidence on the effects of a fiscal devaluation on the real effective exchange rate, the terms of trade and net exports. We focus on countries that joined the Euro Area in 1999 for which fiscal devaluation is a salient issue. We find that the responses are highly heterogeneous across countries and, on average, the estimates provide only a weak support to the theoretical predictions that a fiscal devaluation could affect the real effective exchange rate and the terms of trade. Consistently, we also find negligible results on the trade balance. We conclude that the potential of a V-FD should not be overemphasized, since its effects are rather limited on both relative prices and quantities. Keywords Fiscal devaluation · Exchange rate · Terms of trade · Internal competitiveness JEL Classification E62 · F45 · H87 1 Introduction Until the outbreak of the global financial crisis, countries that join the Euro Area (EA) have shown diverging trends in competitiveness which have fostered the growth of large current account imbalances, with Northern European countries * Debora Assisi Giampaolo Arachi 1 Dipartimento di Scienze dell’Economia, Università del Salento, Via per Monteroni, 73100 Lecce, Italy 13 Vol.:(0123456789) G. Arachi, D. Assisi accumulating surpluses, and Southern countries experiencing current account deficits. In subsequent years, given that a nominal unilateral devaluation was unfeasible within a monetary union, the reduction of external deficits was primarily achieved through internal devaluations which have entailed large economic and social costs (Stockhammer and Sotiropoulos 2014). These experiences have fostered a debate on whether the costs of the adjustment could be reduced by using taxes as a tool to manipulate international relative prices. The literature has long recognized that the real effects of a nominal depreciation may be indirectly achieved, under sticky prices, through a series of revenue-neutral tax shifts which are usually referred to as “fiscal” devaluations. Keynes (1931) first argued that the combination of an import tariff and an export subsidy could lead to a rise in the domestic price of importable and to a reduction in the foreign price of exportable goods. Later, Calmfors (1993, 1998) showed that a reduction in labour taxes matched by changes in other taxes (mainly consumption taxes) could replicate the real allocations of output and employment reached under a nominal exchange rate devaluation. The policy debate in Europe has focused in particular on fiscal devaluation realized through a reduction in employers’ social security contributions (SSCs) compensated by an increase in the value added tax (VAT). When VAT is levied according to the destination principle, exports are zero-rated. Hence, changes in VAT will only affect the prices of both domestically produced and imported goods. With fixed nominal wages, a cut in SSCs would lead to a reduction in labour costs. To the extent that domestic firms will pass these lower costs onto the consumers in the form of lower prices, the proposed tax shift would increase the relative price of imported goods. The decline in the relative price of domestic-produced goods may thus help to improve the trade balance that would also lead to an output growth. This policy has been suggested by the Commission in many recommendations to Member States in the context of the European Semester. The European debate has also been echoed in the debate on the so-called “destination-based cash flow tax” (DBCFT) in the USA. In fact, as argued by Auerbach et al. (2017), a DBCFT would bring about the same economic effects as a rise in the VAT coupled with a reduction in taxes on wages and salaries. Recent literature has focused on VAT-based fiscal devaluation (V-FD) mainly through theoretical analyses. Farhi et al. (2014) have formally analysed the detailed conditions under which a tax shift from SSCs to VAT may exactly replicate the allocations reached under a nominal depreciation. In particular, the authors show that a fiscal devaluation may mimic the effects of a nominal devaluation by producing the same depreciation of the terms of trade (TOT) and the real effective exchange rate (REER) when prices are set in the producer’s currency. Other studies have simulated the impact of fiscal devaluation on growth or trade through general equilibrium models. They suggest that tax shifts from labour to consumption should lead to an output and trade balance improvement, at least in the short run. The positive effect on net exports is however small in magnitude, ranging from 0.3 to 0.6 per cent of GDP, and vanishes some periods after the shock (Annicchiarico et al. 2015; Gomes et al. 2016; Engler et al. 2017). In the long run, in fact, the adjustment in real wages would absorb the reduction in labour costs originally 13 Fiscal devaluation and relative prices: evidence from the… caused by the policy, with a subsequent erosion of the country’s competitive trade advantage. The positive effect on the trade balance is due to depreciation in relative prices. Engler et al. (2017), for instance, find that a fiscal devaluation of 1 per cent of GDP, carried out in Southern European countries, depreciates the REER by 0.3 per cent and deteriorates the TOT by 0.7 per cent, leading to a fairly limited impact on the trade balance, which improves by 0.3 per cent of GDP. Very few papers have sought to provide empirical evidence on the economic effects of fiscal devaluation. De Mooij and Keen (2013) estimate an error correction model for a panel of OECD countries allowing responses to differ according to the exchange rate regime. In particular, for EA countries they find that a shift of 1 per cent of GDP from SSCs to VAT would improve the trade balance by 3.4 per cent of GDP in the short run. Their analysis, however, does not properly account for the possibility of simultaneous tax changes across countries. Holzner et al. (2018) have accounted for the latter issue by focusing on a panel of European Union countries. They find a somewhat smaller effect on the trade balance compared to De Mooij and Keen (2013). Moreover, they argue that the magnitude of the impact varies significantly across countries, suggesting that an accurate analysis on fiscal devaluations should properly account for heterogeneity. Both studies fail to shed light on the channels through which a fiscal devaluation affects th (...truncated)