How Creative Tax Policy Can Substitute for Devaluation

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.

5 thoughts on “How Creative Tax Policy Can Substitute for Devaluation”

  1. “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.

    1. 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!

  2. EXTENDING FISCAL DEVALUATION TO PAYG PERSONAL INCOME TAX

    Why merely REDUCE payroll tax? Why not ABOLISH it altogether? If the revenue were replaced by VAT, domestic retail prices of domestic products need not rise; embedded payroll tax would simply be replaced by embedded VAT. Of course retail prices of IMPORTS would rise due to the higher VAT. But domestic consumers would be compensated by better employment opportunities due to abolition of payroll tax.

    And why stop at payroll tax? The cost of labour for employers can be reduced further — without reducing employees’ “take-home” pay or widening after-tax wage inequalities — by replacing Pay-As-You-Go personal income tax IN THE HANDS OF EMPLOYERS. Employees would continue to receive credit for the PAYG tax withheld by their employers (calculated on their “grossed-up” wages). But businesses, instead of forwarding the withheld PAYG tax to the government, would pay a higher VAT. In the aggregate, the withheld PAYG tax would cover the additional VAT, with no need to raise domestic retail prices of domestic products.

    Three advantages would follow from this combination. First, payroll tax and PAYG personal income tax would be completely removed from the marginal cost of labour as seen by employers. That means more jobs, hence more domestic demand for domestic products. Second, the additional VAT, unlike the tax component of the cost of labour, would not feed into export prices. That means more foreign demand for domestic products. Third, because the extra jobs would reduce welfare spending, not all of the lost revenue from PAYG tax would need to be replaced. That would allow a slight FALL in prices of domestic products.

    I have suggested this replacement of payroll tax and PAYG tax as a lifeline for indebted nations on the edge of the eurozone — in particular, Ireland: http://t.co/u5BtJd5Nxi .

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