Taxes are the Swiss Army Knife of economic and social policy. With enough ingenuity, you can attempt almost any policy goal, from encouraging health insurance to discouraging pollution to stimulating the economy, to name just three. Over at Bloomberg Businessweek, Rina Chandran explains yet another use: helping a troubled economy achieve the moral and economic equivalent of a currency devaluation, without actually devaluing. That’s particularly intriguing for countries in the Euro zone:
The idea of fiscal devaluation originates with John Maynard Keynes. [Harvard Professor Gita] Gopinath’s insight was to advocate fiscal devaluation for Europe’s beleaguered currency union in a 2011 paper she co-authored with her colleague Emmanuel Farhi and former student Oleg Itskhoki, now an assistant professor at Princeton. …
The paper examines a “remarkably simple alternative” that doesn’t require countries to abandon the euro and devalue their currencies to revive growth through exports, Gopinath says. By increasing value-added taxes while cutting payroll taxes, a government can affect gross domestic product, consumption, employment, and inflation much as a currency devaluation would.
The higher VAT raises the price of imported goods as foreign companies pay the levy on the products and services they export to that country. The lower payroll tax helps offset the extra sales tax for domestic companies, reducing the need for them to raise prices. Since exports are VAT-exempt, the payroll cost saving allows producers to sell goods more cheaply overseas, simulating the effect of a weaker currency, according to the paper. The policy also can help on the fiscal front, as increased competitiveness can lead to higher tax revenue, Gopinath says.
“The higher VAT raises the price of imported goods as foreign companies pay the levy on the products and services they export to that country. ”
This is a common misunderstanding of how VAT works. Perhaps it was an unfortunate misunderstanding by the journalist; however, the formulation is clearly wrong. The VAT charged on importation of a product for sale in the EU is always borne by the end consumer and not the “foreign company” that exports that good. If, say, a US company exports a product to the EU, VAT is charged to the importer; but, that importer, usually not the end consumer, is entitled to a refund of that “input VAT” paid on importation. The fact that VAT is ultimately charged to the consumer on goods imported by the EU from abroad simply means that goods imported from abroad by the EU are placed on the same footing as goods that are produced within the EU.
Does the existence of a VAT on imports (and an exemption on exports) actually help a country’s competitiveness? Greg Mankiw (citing Alan Viard) appears to differ from his Harvard colleague:
http://gregmankiw.blogspot.fr/2010/05/is-vat-good-for-exports.html
But, when I first read his argument in 2010, I thought he was missing an important point (apparently the point that Gopinath is making). That is, while VAT is neutral as to domestically manufactured goods and foreign imports, raising significant revenue via a VAT means that other taxes such as payroll tax and corporate income tax that are borne solely by domestic companies can be lowered. This should lower the cost of production and make them more competitive—at least in the short and medium term. Of course, Viard and Mankiw are talking about the long-term—perhaps the very, very long term.
[...] See full story on dmarron.com [...]
It appears that the journalist and the comment above both misinterpret Gopinath’s idea. Here is an example: Assume that an imported item and a domestically manufactured item both costs $10 and the VAT rate is 15%. So then both will cost the end consumer $11.5 and the domestic company’s export price is $10. Then if the VAT is raised to 20% and the payroll tax is lowered so that the domestic company can sell the same product for $9.7, the imported item now costs $12 where the domestically manufactured item costs $11.64, the export price is $9.7 and the domestic consumer is able to pay the difference between the $11.64 and the $11.50 because he is paying a smaller payroll tax.. So the domestic company gets a reduced export price and is more competitive with domestic sales as well and the consumer is kept whole – the only loser is the importer whose retail price is now higher – precisely what was intended!