Which are the effects of a fiscal devaluation?

A fiscal devaluation is likely to have a small, short lived expansionary effect on employment and GDP, points out a study commissioned by European Comission’s Directorate-General for Taxation and Customs Union, and completed by a consortium of eight European research institutes, including ETLA, the Research Institute of the Finnish Economy.

Even if the short-term expansionary effects of a fiscal devaluation fade away over time, results from the assesment of long-run effects of such a policy option point also to a permanent, although small expansion of employment and GDP. Effects on the trade balance are likely to remain small both in the short run and in the long run.

Fiscal devaluation refers to a budget-neutral reduction of payroll taxes matched by changes in other taxes or in government expenditures. For instance employers’ social security contributions might be reduced, with the reduction financed by raising the VAT rate.

When devaluation of a currency is excluded as a policy option (as it is in the Euro Area), and nominal wages are inflexible, competitiveness and employment can be improved by lowering indirect labour costs. On top of the favourable short-term effects come long-term efficiency gains, since the VAT is considered less distortive than social security contributions.

A fiscal devaluation may stimulate the economy by reducing labour costs as nominal wages are not immediately adjusted to the reduction in the social security contribution rate. Consequently, net exports would increase. Moreover, higher VAT rate would depress consumption and imports, while exports are not subject to VAT. As a consequence, output would expand and the trade balance would improve.

However, the results of the simulations reported in the study point at the increase in domestic demand as the cause of favourable short-term effects of a fiscal devaluation. Since the nominal wage is assumed rigid in the short run, a temporary reduction in real labour costs is achieved, resulting in a higher employment and a lower unemployment, and an increased domestic demand.  As the nominal wage is gradually increased, the expansionary effects fade away over time.

In the long run, fiscal devaluation may have favourable effects on the economy due to a shift from wage to consumption taxation. The consumption tax is considered less distortive than the wage tax, because the former is also imposed on existing wealth.

Indeed, according to the simulations much of the favourable long-term effects come from shifting from wage to consumption taxes, which implies redistribution from current to future generations. Existing generations have to pay unexpectedly higher VAT, while they benefit less from the lower social security contributions. Future generations benefit from a less distortive taxation system. As a consequence, long-run consumption increases while the trade balance slightly worsens.

The leader and co-leader of the research project were CBP Netherlands Bureau for Economic Analysis and the Center for the Analysis of Public Policies (CAPP), Universita di Modena. ETLA carried out short-term simulations using the econometric NiGEM model. From ETLA, Paavo Suni and Tarmo Valkonen participated in the writing of the report. The full report “Study on the impacts of fiscal devaluation” is available for downloading on the DG Taxation and Customs Union website.