Abstract
Given that exchange rate devaluations are no longer available in a monetary union, fiscal devaluations are one potential way to address divergence in competitiveness and trade imbalances. Employing a DSGE model calibrated to the euro area, we quantify the international effects of a fiscal devaluation implemented as a revenue-neutral shift from employers’ social contributions to the value added tax. We find that a fiscal devaluation carried out in the South has a strong positive effect on output, which is five times larger than under a wage tax cut. However, the effect on the trade balance and the real exchange rate is mild. The negative effect on the North’s output is weak.
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Notes
Since we have included Ireland in this group, a more precise denomination would be “Ireland and Southern European countries” but in what follows we will use “the South” for simplicity.
CPB (2013, Section 2) surveys the literature on fiscal devaluations.
Farhi and others (2014) use a two-country model to show that a fiscal devaluation can replicate the effects of a nominal exchange rate devaluation, but they numerically evaluate the effects of a fiscal devaluation on a small open economy (Spain). In addition, they do not analyze the role of sticky wages in the transmission of fiscal shocks. Lipinska and von Thadden (2012) model fiscal devaluation as a reduction in labor income taxes, rather than in SCR (see more detailed discussion below). As such, this is not a “pure” fiscal devaluation. Franco (2010) develops a two-country model of a monetary union, but calibrates it to Portugal, virtually ignoring the international transmission of fiscal devaluations.
The household in the North has the following consumption index (the North’s variables are denoted by an asterisk):
$$C_{t}^{*} = \left\{ {\left( {1 - \omega^{*} } \right)^{{\frac{1}{\sigma }}} \left( {C_{t}^{*N} } \right)^{{\frac{\sigma - 1}{\sigma }}}\,+\,(\omega^{*} )^{{\frac{1}{\sigma }}} \left( {C_{t}^{*S} } \right)^{{\frac{\sigma - 1}{\sigma }}} } \right\}^{{\frac{\sigma }{1 - \sigma }}} ,$$where \(\omega^{*}\) is the share of imported goods.
To check the validity of this approach, we compared the convergent impulse responses with the steady state that would result from the new tax rates.
Ivanova (2012), on the other hand, finds that reducing taxes on labor may actually worsen the current account balance.
De Mooij and Keen’s (2013) estimates, using statutory tax rates, show that a 1 percentage point increase of the VAT rate (SCR) increases (reduces) net exports by 0.23 (0.11) percent. These estimates imply that raising the VAT rate by 1 percentage points and reducing the SCR by 1.7 percentage points improves net exports by \(\left( { - 0.11 \times - 1.7} \right) + \left( {0.23 \times 1} \right) = 0.417\) percent of GDP.
Farhi and others (2014) numerically evaluate the effects of a fiscal devaluation on a small open economy, calibrated to match the features of Spain.
Another difference between Lipinska and von Thadden’s (2012) and our approach is their assumption that governments balance their real budgets every period by adjusting labor tax rates every period. We, in contrast, assume that that all government spending is for public transfers to households and that a fiscal devaluation is revenue neutral in the long term. In our model, public transfers in the South increase very mildly in the short term. This implies that our finding that a fiscal devaluation is effective in the short term does not come from lower distortionary taxes that are financed by lump sum taxes or debt in the short term.
In addition, part of the difference in results between our results and those of Lipinska and von Thadden (2012) can be explained by different solution methods. Lipinska and von Thadden (2012) use a first-order approximation, which ignores the cross term, i.e., the change in the tax base times the change in the tax rate. The use of the second-order approximation, in our model, increases the effect of fiscal devaluation on South’s output in the short term by 10 percent.
Drautzburg and Uhlig (2013) use a similar approach.
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*Philipp Engler is Junior professor of Monetary Macroeconomics at Freie Universität Berlin; his email address is: philipp.engler@fu-berlin.de. Giovanni Ganelli is Senior Economist in the IMF's Regional Office for Asia and the Pacific in Tokyo; his email address is: gganelli@imf.org. Juha Tervala is a University Lecturer at the University of Helsinki; his email address is: juha.tervala@helsinki.fi. Simon Voigts is Ph.D. student at Humboldt-Universität zu Berlin; his email address is: s.voigts@hu-berlin.de.
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