Fiscal Devaluation Research Articles

Financial Heterogeneity and Monetary Union

We analyze the economic consequences of forming a monetary union among countries with varying degrees of financial distortions, which interact with the firms' pricing decisions because of customer-market considerations. In response to a financial shock, firms in financially weak countries (the periphery) maintain cashflows by raising markups--in both domestic and export markets--while firms in financially strong countries (the core) reduce markups, undercutting their financially constrained competitors to gain market share. When the two regions are experiencing different shocks, common monetary policy results in a substantially higher macroeconomic volatility in the periphery, compared with a flexible exchange rate regime; this translates into a welfare loss for the union as a whole, with the loss borne entirely by the periphery. By helping firms from the core internalize the pecuniary externality engendered by the interaction of financial frictions and customer markets, a unilateral fiscal devaluation by the periphery can improve the union's overall welfare.

Fiscal devaluation in the Euro area: The role of rigidities, non-tradables, and social security contributions

This paper explores the trade-balance effects of a unilateral fiscal devaluation in a monetary union model with two symmetric countries where the law of one price holds. The paper differs from existing studies in three ways: First, I explore a decrease in the employees’ share of social security contributions (SSC) and show that the view of assuming a decreases in the employers’ share to be more effective does not hold to be true. Second, I explicitly explore the role of nominal rigidities and show that a devaluation implemented in a simple model with flexible prices and wages has noticeable real effects. Moreover, the results indicate that inducing nominal rigidities in fact limits the effectiveness of a fiscal devaluation in raising the trade balance if conducted as a decrease in the employees’ share of SSC. And third, I allow for a different taxation of tradable and non-tradable goods and show that increasing value added taxes (VAT) in a way which affects tradables more than non-tradables is a more effective measure – a result which is at odds with propositions frequently found in literature to abolish reduced rates of VAT. I use these insights to simulate a fiscal devaluation implemented in Euro area countries featuring trade balance deficits in 2015 by using a more elaborate New-Keynesian 2-country model and find that the effectiveness of a fiscal devaluation crucially depends on the fiscal instruments used.

Fiscal devaluations: evidence using bilateral trade balance data

We study the effects of fiscal devaluations on the trade balances of European Union countries over the 2000–2014 period using bilateral trade balance data. This enables us to control for the coincidence of tax policy measures in different countries, which is an aspect left unconsidered in previous econometric studies. A fiscal devaluation consisting of a budget-neutral tax shift in the amount of 1% of gross domestic product (GDP) from employers’ social security contributions to value added tax leads to a short-term improvement of bilateral trade balance ranging between 0.3 and 0.6% of GDP. An extrapolation of our baseline estimate to the overall trade balance yields an impact of 4.3% of GDP for the whole sample, which is slightly higher than presented in previous empirical research. Applying extrapolation to the trade deficit countries in the euro area shows that these countries’ balance of trade with the rest of the euro area improves by only 0.75% of GDP. Thus, the magnitude of the fiscal devaluation impact on the trade balance varies significantly across countries, depending on their trade openness, among other potentially relevant factors.

Third country effects of fiscal devaluations

We analyze fiscal devaluation in a three-country model. The introduction of the third country, outside a monetary union, increases the expansionary effect of fiscal devaluation and the second country of the monetary union experiences a boom instead of a recession.

Bilateral trade effects of fiscal devaluation: Evidence from OECD countries

ABSTRACTThis paper empirically examines the effects of a fiscal devaluation on bilateral trade. To this end, employers’ social contribution (ESC) and value-added tax (VAT), which stand as the factors that represent typical fiscal devaluation, are embodied within the framework of a gravity model. Fixed effects vector decomposition (FEVD) technique is applied to the empirical models specified within this framework, employing panel data from 22 OECD countries over the 1980–2014 periods. The findings show that the effectiveness of the fiscal devaluation policy seems to alter with respect to how ESC and VAT are measured. Considering the fiscal devaluation policy implemented unilaterally, the policy turns out to be effective in nine countries in the sample.

Macroeconomic and generational impacts of fiscal devaluation: an application for the Brazilian case

A desvalorização fiscal normalmente envolve a redução das contribuições para a seguridade social sobre a folha de pagamento com o aumento do imposto sobre o consumo. Este estudo avalia o impacto da desvalorização fiscal no Brasil sobre o consumo, capital, produção e distribuição de renda entre gerações. Para isso, usamos um modelo dinâmico de equilíbrio geral com gerações sobrepostas, expectativa de vida finita, risco de morte e seguridade social. Os resultados sugerem que a desvalorização fiscal provocou resultados positivos, mas modestos, sobre o produto, capital e consumo a longo prazo, sem grandes sacrifícios para a economia no seu caminho de transição.

Can Fiscal Budget-Neutral Reforms Stimulate Growth? Model-Based Results

This paper focuses on growth enhancing budget-neutral fiscal reforms, i.e. changes in the composition of government revenues and spending that stimulate GDP growth while keeping the ratio of the fiscal budget to GDP constant. To this aim, we present simulation results using a multi-country DSGE model with three large economic regions, the US, the euro area and the rest of the world. The model features constrained and unconstrained non-Ricardian households and a detailed government sector; its multi-country nature allows investigating cross-country spillovers. The paper focuses on the most growth-friendly budget-neutral fiscal measures: (i) an incomplete fiscal devaluation (ii) a rise in government investment compensated by a fall in government consumption and (iii) a rise in government investment compensated by a rise in consumption and labor taxes. Dampening or amplifying effects due to coordination across policies (monetary and fiscal) and across economic regions are also considered. Three main results stand out. First, an increase in government investment financed by rising less distortionary taxes appears to be an effective growth-friendly budget-neutral reform in the sense that it generates both short- and long-run GDP growth and improves fiscal sustainability. Second, benefits and costs of budget-neutral reforms are not equally distributed across agents, giving rise to a policy trade-off between growth and distributional consequences. Third, budget-neutral reforms do not have large cross-border trade spillovers; however, reforms coordinated across all countries in periods of accommodative monetary policy do have amplified domestic effects.

Fiscal Devaluation in a Monetary Union

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.

Stabilization and Rebalancing with Fiscal or Monetary Devaluation: a Model-Based Comparison

The article uses a small open economy version of the macroeconomic general-equilibrium model QUEST to compare fiscal and nominal exchange rate (EXR) devaluation with respect to their impact on economic activity and the current account. In particular, the article investigates quantitatively to which extent fiscal devaluation mimics nominal EXR adjustment and mitigates the output loss associated with demand rebalancing and external adjustment by shifting adjustment from domestic demand contraction to export growth. Fiscal and monetary devaluation support external adjustment and mitigate its impact on economic activity in the presence of price and wage rigidities. The quantitative impact of a tax shift from labour to consumption as the standard example of fiscal devaluation remains very moderate, however (JEL codes: E52, F41, F47).

Internal Devaluation in Currency Unions: The Role of Trade Costs and Taxes

This paper studies export adjustment to negative shocks in currency unions. I consider the hitherto ignored role of trade costs and taxes in internal devaluations, which have been brought to the fore of international policy during the recent euro periphery crisis. Trade costs can limit the pass-through of internal devaluation on export prices. Using data on export prices ”on the dock”, I document that higher trade costs are associated with a lower reduction of export prices relative to domestic prices in the euro periphery. Furthermore, VAT (in theory trade neutral, but in practice much higher on tradables) hikes prevent the required shift of resources towards tradables. I show that the real exchange rate (RER) adjustment was heavily affected by indirect tax hikes, by comparing headline RER and tax-adjusted RER. I then build a standard New Keynesian small open economy model with sticky wages and prices, incorporating trade costs and indirect taxes (allowing for VAT imperfections), and show that both these frictions, but especially trade costs, can be quantitatively crucial in affecting export growth, more so than either product markups or wage rigidity. I apply the model to data for Greece, the least successful of the euro periphery fiscal devaluation programs, and show that it can account for the most salient features of the data; trade costs explain the failure to substantially raise exports, and taxes the initial small fall in exports. JEL Classification: F32, F33, F41, F45

Internal Devaluation in Currency Unions: The Role of Trade Costs and Taxes

This paper studies export adjustment to negative shocks in currency unions. I consider the hitherto ignored role of trade costs and taxes in internal devaluations, which have been brought to the fore of international policy during the recent euro periphery crisis. Trade costs can limit the pass-through of internal devaluation export prices. Using data export prices on the dock, I document that higher trade costs are associated with a lower reduction of export prices relative to domestic prices in the euro periphery. Furthermore, VAT (in theory trade neutral, but in practice much higher tradables) hikes prevent the required shift of resources towards tradables. I show that the real exchange rate (RER) adjustment was heavily affected by indirect tax hikes, by comparing headline RER and tax-adjusted RER. I then build a standard New Keynesian small open economy model with sticky wages and prices, incorporating trade costs and indirect taxes (allowing for VAT imperfections), and show that both these frictions, but especially trade costs, can be quantitatively crucial in affecting export growth, more so than either product markups or wage rigidity. I apply the model to data for Greece, the least successful of the euro periphery fiscal devaluation programs, and show that it can account for the most salient features of the data; trade costs explain the failure to substantially raise exports, and taxes the initial small fall in exports.

Is There a Need for Fiscal Devaluation to Spur Economic Growth?

The idea of reducing insurance contributions from the current 30% to 21–22% while raising the VAT rate from 18% to 21–22% has been debated a lot since late in 2016. It is assumed that such a tax manoeuvre can reduce domestic producers’ labour costs, and neither exporters nor investments will be affected by VAT growth because the former are entitled to VAT refund and the latter are eligible for a VAT credit for investment goods. Accordingly, it is expected that financial benefits for businesses may subsequently speed up economic growth rates, as well as have a positive effect on the employment rate and on the balance of trade. The question is whether these expectations are reasonable enough.

The euro crisis, fiscal devaluation, and impacts on the tourism sector in the Spanish economy

The current account imbalances between northern and southern euro area countries from 1998 to 2007 have been considered one of the key problems in the euro crisis. Cumulated over 12 years, the sustained differentials of high inflations in south countries led to a cumulative price differential relative to the north countries and contributed to the deterioration in competitiveness. In addition, south countries cannot use nominal currency devaluation, as it used to do before. Because of the high costs of internal devaluation, the policy option of a tax combination can replicate the effects attained under nominal exchange rate devaluation. In this article, we analyze the impacts of a fiscal devaluation on the tourism sector in the case of Spanish economy.

Trade and fiscal imbalances in Southeastern Europe: Can fiscal devaluation help?

We examine the need, potential and likely effects of fiscal devaluation for a group of seven economies in Southeastern Europe. All the countries face external trade imbalances and most of them also experience large or growing fiscal problems. We conclude that fiscal devaluation could be a useful instrument to help these countries improve their trade balances without (further) deteriorating their fiscal positions. The results of our simulations show that a budget neutral fiscal devaluation in the amount of 1 percent of gross value added could yield short-run improvements in trade balances ranging from 0.56 to 0.94 percentage points of (initial) gross value added. Simultaneously, this is expected to have a positive impact on output as well, which should grow at rates between 0.15 and 0.25 percent.

Is fiscal devaluation welfare enhancing?

Due to the experience of large external imbalances and misaligned real exchange rates within the euro area, the concept of fiscal devaluation has gained increasing attention, which mimics the effects of external devaluation in the absence of flexible nominal exchange rates and an independent monetary policy. This paper uses a small open economy model with nominal wage and price rigidities to analyse the welfare effects of fiscal devaluation, understood as budgetary-neutral tax shift from employers' social security contributions towards consumption tax. The paper finds that fiscal devaluation can support external rebalancing by accelerating real exchange rate adjustments and regaining price competitiveness. From a household welfare perspective, internal devaluation with its concomitant worsening of the terms of trade tends to induce welfare losses. The overall welfare effects are pro-cyclical in the sense that the stronger the tax shift, the higher the welfare losses for the average household. The losses increase with the openness of the economy and the relative size of the tradable sector. In the presence of supply shocks, however, fiscal devaluation can imply small welfare gains. A scenario with flexible nominal exchange rates and autonomous monetary policy performs better in terms of household welfare, but implies stronger external fluctuations in the short run.

Optimal Fiscal Substitutes for the Exchange Rate in a Monetary Union

This paper studies Ramsey-optimal monetary and fiscal policy in a New Keynesian 2-country open economy framework, which is used to assess how far fiscal policy can substitute for the role of nominal exchange rates within a monetary union. Giving up exchange rate flexibility leads to welfare costs that depend significantly on whether the law of one price holds internationally or whether firms can engage in pricing-to-market. Calibrated to the euro area, the welfare costs can be reduced by 86% in the former and by 69% in the latter case by using only one tax instrument per country. Fiscal devaluations can be observed as an optimal policy in a monetary union: if a nominal devaluation of the domestic currency were optimal under flexible exchange rates, optimal fiscal policy in a monetary union is an increase of the domestic relative to the foreign value added tax.

Fiscal devaluation in the euro area: A model-based analysis

We assess the effects of a temporary fiscal devaluation enacted in Spain on the trade balance by simulating EAGLE, a large-scale multi-country dynamic general equilibrium model of the euro area. Social contributions paid by firms are reduced by 1% of GDP for four years and are financed by increasing the consumption tax. Our main results are the following. First, in the first years following implementation the Spanish trade balance improves by around 0.6% of GDP, the (before-consumption tax) real exchange rate depreciates by 0.7% and the terms of trade deteriorate by 1.3%. Second, the trade balance improves when the temporary fiscal devaluation is also enacted in the rest of the euro area, albeit to a lower extent than in the case of unilateral (country-specific) implementation. Third, similar results are obtained if we consider the case of a smaller euro area economy, specifically Portugal. Fourth, quantitative results are robust to changes in some key parameters but crucially depend on the degree of substitutability between domestic and imported tradables.

Public Finance Systems for Coping with the Crises: Lessons from the Three Baltic States

Of all EU member states the three Baltic countries were hit the hardest by the economic crises in 2008–2010 but they recovered relatively quickly, with all three countries even being able to qualify for EMU membership (Estonia joined the Eurozone in 2011, Latvia in 2014 and Lithuania in 2015). The speed and determination with which the Baltic countries carried out austerity measures is often put forward as an example for other E(M)U member states. This paper critically assesses the validity of various models of austerity (expansionary fiscal contractions, internal devaluation and fiscal devaluation) when applied to the case of the Baltic States. It is argued that in the case of the Baltic countries more complex economic mechanisms were at play then these models suggest. In the paper specific attention is paid to the way fiscal consolidation was shaped in the three countries, and to the role of EU structural funding. The paper concludes with a discussion of the lessons that can be learned for other EU countries.

Tax structure and macroeconomic performance

This paper reassesses the relationship between tax structure and long-run income, using as indicators of tax structure both a new series of implicit tax rates based on Mendoza et al. (J Public Econ 66:99–126, 1997) and tax ratios, adopting a dynamic panel estimation strategy, and explicitly accounting for cross-sectional dependence in the panel. When implicit tax rates are used, the paper shows that the link between tax structure and long-run income per capita is not robust to the adoption of different assumptions on observable and unobservable heterogeneity across countries. When tax ratios are used, there is some evidence of a negative impact of labour taxation on long-run income, but this result is shown to capture non-fiscal effects coming from the evolution of the labour share. Turning to the short run, the research presented here finds strong evidence of a positive effect on per capita income of a tax shift from labour and capital taxation towards consumption taxation, which provides support for fiscal devaluations.

Opportunities for fiscal devaluation in small open economies: the case of Ukraine

This article examines the effects of fiscal devaluation on the trade balance of a country with a small open economy. It is assumed that typically such countries are price takers, which means low price elasticity of exports and imports. If this assumption is true, then it is impossible to make an impact on the trade balance through the price mechanism and, accordingly, fiscal devaluation will not have significant effects. To confirm or reject this hypothesis it is necessary to determine causal relationships between changes in the fiscal devaluation indicator and trade balance dynamics. Applying a series of causality tests to Ukrainian data, the authors argue that the dynamics of trade balance cause changes in VAT and social security contributions. The opposite causality was not detected. This is treated as evidence of fiscal devaluation's inefficiency in economies like Ukraine on one hand and of the price-taking characteristics of Ukraine on the other. The potential null effect of fiscal devaluation was confirmed with SVAR modeling.