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On the merits of fiscal devaluations

Publishing date
27 March 2012

Fiscal devaluations are at the heart of current debates about improving trade competitiveness in the eurozone. Gita Gopinath, Emmanuel Farhi and Oleg Itskhoki provided a strong model to assess the effects of such an enterprise. The idea of simulating a devaluation by means of taxation goes back to Keynes, who suggested using an import tariff combined with an export subsidy to raise the price of imports while reducing the foreign price of export goods. The use of an export subsidy was also recently suggested by Marzinotto, Pisani-Ferry and Wolff to kick start growth in Southern European economies. A new IMF paper by Ruud de Mooij and Michael Keen reviewed a number of such experiences and tries to put the theory of fiscal devaluation to the test.

De Mooij and Keen consider fiscal devaluations by means of changes in VAT rates by shifting away from production-based taxes such as employers’ social security contributions, and offsetting the revenue loss by raising destination-based taxes such as the VAT. The underlying assumption is that the reduction in contributions is passed onto producer prices. The new producer prices will result in a lower price for exports and because the VAT affects both imports as well as domestically produced goods, the relative consumer price of imports goes up.

But there is a caveat to the effectiveness of a fiscal devaluation, the extent to which reductions in contributions are passed to producer prices depends on the degree of competition in the economy and as a result is likely to be more successful in some countries than in others.  Additionally, VAT increases can have negative impacts on sectors vital for the functioning of the economy, as would be the case of the Greek tourism industry for instance. This in turn would weaken the power of the devaluation.

De Mooij and Keen find that for several countries in the sample considered (30 OECD countries during 1965-2009) domestic tax reforms can have effects in line with the theory on trade. In some instances, these include a short run increase in net exports and a positive shift in GDP. The paper does point out however that, over the medium term, the evolution of nominal wages tends to erode the early benefits of fiscal devaluations.

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