Fiscal devaluation: the case of Portugal Taxes and competitiveness with a fixed exchange rate Francesco Franco Nova SBE March 2, 2012 Francesco Franco Fiscal devaluation: the case of Portugal 1/34
Outline 1 An outline of Portugal Imbalances 2 The Market based economic adjustment Competitive disinflation Impediment to market based adjustment: wage rigidity Impediment to market based adjustment: market power in the non-tradable 3 Fiscal Devaluation through a labour-consumption tax swap 4 The Portuguese case 5 Conclusions Francesco Franco Fiscal devaluation: the case of Portugal 2/34
The Net External Position is large, negative and difficult to sustain External Net Position Net External Position -1.5 -.5 01995q1 2000q1 2005q1 2010q1 Accumulated current account NIIP The data are shown as a percentage of GDP.Sources:Banco de Portugal and Eurostat -1.5-1 -.5 0 1995q1 2000q1 2005q1 2010q1 Accumulated current account NIIP The data are shown as a percentage of GDP.Sources:Banco de Portugal and Eurostat Francesco Franco Fiscal devaluation: the case of Portugal 3/34
Portugal Aggregate Demand dynamic during 1999-2011 Francesco Franco Fiscal devaluation: the case of Portugal 4/34
Portugal Aggregate Supply dynamic during 1999-2011 Francesco Franco Fiscal devaluation: the case of Portugal 5/34
Portugal Imbalances The Portuguese economy is in serious trouble: Productivity growth is anemic. Growth is very low. The budget deficit is large. The current account deficit is very large. Olivier Blanchard (2007) Francesco Franco Fiscal devaluation: the case of Portugal 6/34
Equilibrium response to Portugal Imbalances What should we expect? Intuition from convergence in a New Keynesian SOE model Francesco Franco Fiscal devaluation: the case of Portugal 7/34
Competitive Disinflation Market based adjustment mechanism within Euro (fixed exchange rate area) Competitive disinflation: unemployment increases and pushes the growth rate of nominal wages down until the country s competitiveness is restored Market based mechanism that takes place within a fixed exchange rate system to adjust to external imbalances (in the absence of fiscal transfers and with limited labor mobility/migration) It is a painful mechanism that relies on two key market transmission mechanisms: 1 the decrease in nominal wages in face of higher unemployment 2 the decrease in prices in face of a decrease in the wages Francesco Franco Fiscal devaluation: the case of Portugal 8/34
Impediment Wage rigidity in Portugal Figure: Share of workers that would have a nominal wage cut, in the absence of rigidity,and have instead nil wage changes. Source: Cláudia Duarte, BdP, 2008 Francesco Franco Fiscal devaluation: the case of Portugal 9/34
Impediment Wage rigidity in OECD Figure: Real and Nominal Rigidity by Country. Fraction of Workers Potentially Affected. Source: Dickens et al., 2007 Francesco Franco Fiscal devaluation: the case of Portugal 10/34
Non-Tradable Goods Non-Tradable - Tradable - External Deficit Figure: The Non Tradable Sector in context Francesco Franco Fiscal devaluation: the case of Portugal 11/34
Non-Tradable Goods are difficult to identify Many industries produce goods that fit into both non-tradable and tradable categories, for example banking services. Need to adopt subjective/discretional choices: imports plus exports equal to at least x% geographical concentration (tradable are more concentrated) In disinflation framework correct concept: goods that consumer cannot buy from a non-resident producer Francesco Franco Fiscal devaluation: the case of Portugal 12/34
Tradable Goods are easier to identify Figure: Sectorial composition of value added in the euro area Francesco Franco Fiscal devaluation: the case of Portugal 13/34
Tradable Goods had an unfavorable evolution in Portugal Figure: Evolution of pure Tradables share in the euro area Francesco Franco Fiscal devaluation: the case of Portugal 14/34
Non-Tradable goods Effect on the Balance of Payments Non-tradable goods cannot be exported and therefore cannot directly improve the trade balance Non-tradable firms with international presence can improve current account through income payments if ownership is resident Lower competition in Non-Tradable (by definition only resident competition) allows prices to increase above productivity causing an appreciation of the real exchange rate (REER) Francesco Franco Fiscal devaluation: the case of Portugal 15/34
ULC Eurozone 1995-2010: Germany is not outlier in Manufacturing Figure: Evolution of sectorial ULC Francesco Franco Fiscal devaluation: the case of Portugal 16/34
Policy response to Portugal Imbalances Equilibrium response corresponds to the market based adjustment in the economy: at best slow in Portugal Accelerate/Initiate response requires: an improvement in the current account through an improvement in the trade balance an increase in private savings (decrease in consumption) In the old days Portugal would devaluate, today both objectives could be achieved with a tax swap from employers contributions to social security (TSU) to VAT (IVA) complemented with wage moderation Francesco Franco Fiscal devaluation: the case of Portugal 17/34
A framework Long and Short Run Distinguish between Medium/Long run: effects of the tax-swap on the supply side of the economy such as distributive and allocation effects Short run: effects of the tax-swap on the demand side of the economy: analogy with nominal devaluation that reduces unit labour costs (increase competitiveness), expands exports and reduce imports but neutral in the Long run Francesco Franco Fiscal devaluation: the case of Portugal 18/34
Policy alternatives to Portugal Imbalances Francesco Franco Fiscal devaluation: the case of Portugal 19/34
Tax swap history The debate whether employment and output prospects of European countries can be improved via broad-based shift of the tax structure is old (the dual dividend tax strategy suggested in the Delors Plan) In the US there are proposals of a green tax swap (labour tax-energy tax) Actual examples of fiscal devaluation in Germany: increase VAT by 3% and partially offset with a decrease in ESSC Francesco Franco Fiscal devaluation: the case of Portugal 20/34
Portugal taxes Table: VAT and ESSC in Portugal, year 2007 Tax Basis Tax rate Revenue Effective tax rate Consumption 65% 21% 8.79% 10.81% Gross Wages s.t. Tax 40.4% 23.7% 8.68% 21% Francesco Franco Fiscal devaluation: the case of Portugal 21/34
Portugal taxes VAT rate has increased substantially in PT Francesco Franco Fiscal devaluation: the case of Portugal 22/34
Portugal data Quarterly data set starts 1995: VAT, TSU, Private Consumption, Compensation (inclusive of TSU), Exports, Imports VAT rate has been changed several times both general and reduced: effective tax changed TSU did not change but some legislation passed might have affected the effective tax Small 3 Variables SVAR, 2 lags, dummy financial crisis, with recursive structure: effective vat -> consumption -> imports effective tsu -> ulc -> exports Francesco Franco Fiscal devaluation: the case of Portugal 23/34
Portugal data Figure: Effective and general VAT rates in Portugal. Source: Eurostat Francesco Franco Fiscal devaluation: the case of Portugal 24/34
Portugal data Figure: The effect of a shock to the effective VAT rate on consumption and imports. Francesco Franco Fiscal devaluation: the case of Portugal 25/34
Portugal data Figure: Effective SSC rate in Portugal. Source: Eurostat Francesco Franco Fiscal devaluation: the case of Portugal 26/34
Portugal data Figure: The effect of a shock to the effective social security rate on wages and exports. Francesco Franco Fiscal devaluation: the case of Portugal 27/34
Results Table: Percentage response to a one standard deviation increase in t w shock, CI 68% Horizon t c on imports 2 years [-3.5,-6.27,-8.99] 5 years [-2.9,-8,-13.24] Table: Percentage response to a standard deviation shock in t w, CI 68% Horizon t w on g x 2 years [-0.6,-2.38,-4.17] 5 years [-0.30,-2.79,-5.28] Francesco Franco Fiscal devaluation: the case of Portugal 28/34
Results Francesco Franco Fiscal devaluation: the case of Portugal 29/34
Conclusions Portuguese lessons Portugal must rebalance its economy towards higher savings and greater competitiveness A revenue neutral tax-swap between ESSC and VAT could achieve both objectives with sticky wages but NT: final producer prices must fall To achieve a larger reduction of the ESSC VAT should be increased substantially and special regimes should end Policy to achieve rebalancing within the euro area consistent with global rebalancing Francesco Franco Fiscal devaluation: the case of Portugal 30/34
Conclusions The Euro Area is unbalanced within Francesco Franco Fiscal devaluation: the case of Portugal 31/34
Conclusions The Euro Area is balanced Francesco Franco Fiscal devaluation: the case of Portugal 32/34
References A Alesina and R Perotti. The welfare state and competitiveness. The American Economic Review, pages 921 939, 1997. O Blanchard. Adjustment within the euro. the difficult case of Portugal. Portuguese Economic Journal, 6(1):1 21, 2007. D Cavallo and J Cottani. For greece, a fiscal devaluation is a better solution than a temporary holiday from the eurozone. Voxeu.org, Feb 2010. Ruud de Mooij and Michael Keen. Fiscal Devaluation and Fiscal Consolidation: The VAT in Troubled Times. IMF Working Paper Francesco Franco Fiscal devaluation: the case of Portugal 33/34
References Farhi E., Gina Gopinath and Oleg Itskhoki, Fiscal Devaluations, NBER WP 17762 PR Krugman and MS Feldstein. International trade effects of value added taxation. NBER Working Paper, 1989. A Lipinska and L Von Thadden. Monetary and fiscal policy aspects of indirect tax changes in a monetary union. Working Paper Series, Jan 2009. Francesco Franco Fiscal devaluation: the case of Portugal 34/34