Readers Question: Can you please elaborate on “fiscal devaluation” as a suggested solution for Euro area competitiveness problems?
Fiscal devaluation is an attempt to restore competitiveness through changes to the tax system.
In an exchange rate devaluation, a country allows its currency to fall in value. This makes the countries exports cheaper and more competitive; imports become more expensive. This leads to relatively higher domestic demand. A devaluation can help reduce a current account deficit.
Fiscal devaluation aims to improve competitiveness by changing tax rates which reduce the cost of exports.
- The government could cut tax on labour (e.g. Employer, employee income tax contributions)
- To offset these tax cuts, the government could increase VAT
- Lower tax rates on labour effectively reduce wage costs. This should make exports cheaper and more competitive.
- Higher rates of VAT make goods sold in that country more expensive.
Thus by changing the burden of taxation, the government is able to reduce wage costs and improve export competitiveness.
For fiscal devaluation to be successful, it is important that:
- Workers don’t bargain for higher nominal wages because of the higher VAT rates. (if wages rise, this will offset the decline in tax costs)
- Firms use lower tax rates to cut export prices rather than maintaining same export price and gain a bigger profit margin from the lower tax rates.
Potential Benefits of Fiscal Devaluation
- Can help countries who are uncompetitive, but can’t devalue. In particular this applies to Eurozone countries such as Portugal, Ireland and Greece who are all in Euro, but can’t devalue.
- Can help make a contribution to reducing current account deficit. For many Eurozone countries are faced with record current account deficits (close to 10%, which indicates how uncompetitive they have become in single currency.
- It is often one of the few practical solutions to improving short run competitiveness for countries
- Lower income tax may also increase incentives to work and avoid tax evasion. By increasing VAT and reducing income tax, there is a greater incentive to seek work to find jobs.
Potential Problems of Fiscal Devaluation
- Regressive Nature of Tax Changes. VAT tends to be more regressive than income tax rates. Fiscal devaluation can increase the cost of basic household necessities which reduce the living standards of the lowest paid.
- It doesn’t actually change underlying productivity and competitiveness. Tax changes could even be an excuse to avoid improving underlying productivity.
- The effect of fiscal devaluation will be limited if other countries try a similar approach of switching to indirect taxes and lower labour taxes.
- There is a limit to how much you can reduce taxes on labour.
- Once labour taxes have been cut, a government may be reluctant to reverse changes which reduce competitiveness.
- Depends on how labour intensive an industry is
- Depends on elasticity of demand for exports.
- Effect tends to wear off after a few years as nominal wages adjust.