Composition of trade flows and the effectiveness of fiscal devaluation

Abstract

AbstractWe empirically explore whether the magnitude of the effects of fiscal devaluation, which consists of reducing the employers’ social security contribution rate and increasing the value‐added tax rate, depends on the composition of trade flows. Our sample comprises data on bilateral balances of trade between 28 European Union (EU) Member States and their main EU trade partners over the 2000–14 period. We use robust ordinary least squares regressions, controlling for the country‐pair and time fixed effects, to test whether there are differences in the sizes of relationships between these taxation forms and bilateral trade balances for different types of goods, by distinguishing between: (i) consumer, intermediate and capital goods; and (ii) labour and capital‐intensive goods. Our results show that the overall effectiveness of fiscal devaluation depends on the composition of trade flows. Value‐added tax is more strongly (positively) associated with (bilateral) balances of trade in consumer goods, compared to balances of trade in capital and intermediate goods. The employers’ contribution rate, in contrast, is more tightly (negatively) related to balances of trade in capital goods. The latter finding also holds true for trade balances of labour‐intensive goods compared to balances of capital‐intensive goods.