Academic Perspectives on Sovereign Default, Austerity and VAT Hikes as a Substitute for Currency Devaluation

This post was written by Philip Lane

Harvard’s Gita Gopinath is interviewed on these topics in the Review of Economic Dynamics Newsletter here.

21 Responses to “Academic Perspectives on Sovereign Default, Austerity and VAT Hikes as a Substitute for Currency Devaluation”

  1. Joseph Ryan Says:

    @Philip Lane

    Does a tax increase constitute austerity in an economic sense?

    If so I am all for austerity.
    A super tax of 15%-25% on all income in excess of €60,000 as item one on the agenda for a program country.
    How come such an item never appears on an austerity list?

  2. Dom K. Says:

    Joseph,

    Perhaps you should read the article first.

  3. BeeCeeTee Says:

    Someone tell Michael Noonan, in case he runs short of ammunition …

    “In the absence of a currency adjustment, a combination of an increase in value added taxes (with border adjustment) and a uniform cut in payroll taxes can deliver the same outcomes. An increase in VAT will raise the price of imported goods as foreign firms face a higher tax and it will lower the price of domestic exports (relative to domestic sales prices) since exports are exempt from VAT. The net effect is a deterioration in the terms of trade equivalent to that following a currency devaluation.”

  4. BeeCeeTee Says:

    Actually, there’s something not precisely right in that quote when applied in the Irish context. The benefits may be greater.

    There’s a good chance that some foreign firms will respond to a VAT increase, at least in part, by cutting margins rather than increasing prices. Many of them still have so much fat in their prices that trimming a percent or two off the “price for Ireland” may be more attractive than raising the shelf price in tough, penny-watching times.

  5. seafóid Says:

    In his rather good Minsky moment piece back in 2008 Muenchau suggested

    more exchange-rate flexibility in countries with fixed or semi-fixed exchange rates

    http://www.ft.com/intl/cms/s/0/9c760d54-4bc0-11dd-a490-000077b07658.html#axzz1eTbvRDXY

    As a way to deal with the crisis. How would this work in a Euro setup assuming the borgs in charge were open to suggestions ?

  6. Eureka Says:

    @ BeeCeeTee
    If you devalue a currency don’t you make the Irish product cheaper relative to the import? An increase in VAT doesn’t yield a competitive advantage to the Irish product in the domestic market whereas currency devaluation does?

  7. David O'Donnell Says:

    Percentage error of +45% of GDP does tend to mess up quite a few analyses of what used to be known as orthodoxy; high infants graduates, whatever about their teacher, have no bother at all at all in figuring this one out.

  8. The Dork of Cork Says:

    Is the VAT policey all about creating synthetic inflation so that the ECB has the excuse to raise rates again ?
    Not about reducing imports and improving our domestic trade balance.
    The scattergun 2% rate would not improve our trade balance as Pints of Beamish would also rise domestically.
    The Labour Health Police loves this shit as they get to do something economically pointless but can at least sustain their cultural war games.
    Me thinks these ECB Boys behind the curtain are Bad Bastards.

  9. Garry Says:

    Imagine some company where labour is the big part of their offering… they are not just taking stuff in adding a margin and reselling….
    say a small services firm, a solicitors, an accountancy practice, cleaners, builder, cleaners which has to charge VAT. Worse still imagine that firm is trying to sell to the public i.e. those who are not VAT registered…
    So before they pay a cent of any other taxes or rent they now have to work almost 1 day in 4 to collect VAT…up from 1 day in 5… Or even consider someone selling into Europe/UK where they suddenly are even less competitive.

    I’m thankful I’m not in that position; it seems from reading the articles/comments on the VAT rise here nobody even thinks about this…

    The purpose of an internal devaluation is to make domestically produced goods and services less expensive not more.

    Changing the system so the state gets an even bigger part of the pie, when the pie is shrinking is not devaluation… and to attempt to present it as such is deeply dishonest.

    How will this allow for exports to be more competitive? How will this allow people to have a reasonable life on less money? How will this help firms become more competitive wrt to their international competitors…

    Exactly how will forcing firms to hand over 2% more of their sales to the government help those firms, their customers and employees?

    I think as a first step VAT should be applied to university fees and registration charges, it might help some understanding of what VAT actually is….

  10. Peter Stapleton Says:

    A key point in the interview is that a VAT increase combined with a drop in labour taxes can be similar to a devaluation.
    We are facing the first part of this recipe, but not the second.

  11. Colm Brazel Says:

    Re: ” An increase in VAT will raise the price of imported goods as foreign firms face a higher tax and it will lower the price of domestic exports (relative to domestic sales prices) since exports are exempt from VAT. The net effect is a deterioration in the terms of trade equivalent to that following a currency devaluation. ”

    What nonsense, the net effect is loss of jobs, destruction of the local business and trade cycle, penal tax on business, austerity loaded on those on poorer incomes whose proportional spend and VAT vulnerability is far higher than those on higher incomes, who can save or spend abroad or find other ways around vat!

    Currency devaluation is where all earnings and savings and incomes get hit and the burden is shared across the whole currency.

    Devaluation a la VAT can be good and make us more competitive?

    ROFL. Lol.

  12. Garry Says:

    Sorry Peter but thats just wrong… Theres no other way to put it.

    OK, reducing labour taxes can mean that workers can get more take home pay for the same outlay from employers but some workers are more equal than others.

    Does it matter if VAT goes to 50% for state legal services? Hell no, the state is paying, it doesn’t matter… it’ll even push up the GDP figures and some social partner can use that to justify their wages… Does it matter if you are a business person and are paying a professional to advise on a patent…. Or a private consumer ……… See what I mean?

    Mandatory fees, regulatory charges etc etc etc… Some are VAT exempt , and most are going to state coffers. The cost of doing business is increased, the % of wealth that is taken by the state is increased.

    Devaluation would automatically hit all these other hidden and protected charges.

    If you want to do it honestly, reduce all the state charges by the target %. Reduce the amount they pay for services, reduce the wages, reduce the welfare rates, the grants, the subsidies etc

    How would the VAT proposal induce an effective devaluation in the education sector? To take just one.

    Trying to sell a VAT rise as a devaluation is like p***ing on my back and telling me its raining.

  13. Colm Brazel Says:

    To be fair to Gita, perhaps in the above she is being less than opaque in her reasoning.

    I’ve taken ” The net effect is a deterioration in the terms of trade equivalent to that following a currency devaluation. ” meaning, there can be positive consequences for trade.

    If instead she means, the negative effects will be destructive, and this is a critique of VAT increase, then I would agree with her.

    Overall, her logic and clarity leaves much to be desired:)

  14. zhou_enlai Says:

    I think Lawrence Summers wrote an article in the FT on Monday questioning the effectiveness of wage deflation to improve competitiveness in circumstances where the knowledge economy skews income towards those at the top.

  15. Garry Says:

    +1 Colm…

    very valid point on savings… and debts etc

  16. zhou_enlai Says:

    Gita Gopinath decouples the [i]public[/i] debt reduction element from the trade stimulation element.

    This is a questionable premise in circumstances where some economies in the eurozone which she refers to are labouring under back-breaking private debt. It is also questionable insofar as it seems to suggest that the only stimulus worth

    Gita Gopinath does not comment on:
    1. The stimulatory effect which the reduction of private debt, through inflation following on from devaluation, can have.
    2. The negative effect of the reduction of private wealth.

    Perhaps Gita Gopinath is assuming that reasonable corporate and personal insovency regimes apply in the countries referred to. Even so, there are significant costs to involved even if such systems are in place.

    Because Gita Gopinath separates (i) public debt from (ii) the stimulatory effect through increased export competitiveness, and leaves nothing in between, I find her analysis wholly unconvincing.

  17. Philip Lane Says:

    @Zhou

    the underlying academic article by Gopinath recognises that the full replication of a devaluation may also require some level of default on external debt.

  18. Joseph Ryan Says:

    @DOM K

    re “Perhaps you should read the article first”

    When I do read the article do you think I will find an answer to the question posed. Or is it that you don’t like the thought of income tax increases.

    Indeed when you have read through the article you might let me know, based on the article, where and why income tax increases are excluded from a consideration of austerity measures.

  19. Kevin Donoghue Says:

    The Fiscal Devaluations paper by Farhi, Gopinath and Itskhoki says: “Keynes (1931) had conjectured that a uniform ad valorem tariff on all imports plus a uniform subsidy on all exports would have the same impact as an exchange rate devaluation.” Presumably this is somewhere in Essays in Persuasion, does anybody know where?

  20. Kevin Donoghue Says:

    Joseph Ryan,
    Philip Lane’s heading may have misled you. The question the interviewer put to Gopinath was “Aside from drastic austerity measures, what are possible policies?” A hike in VAT coupled with payroll tax cuts is a fair answer since it can’t be called austerity if the combination is revenue-neutral.

  21. zhou_enlai Says:

    @Philip Lane

    I take your point. It is hard to be comprehensive in interview answers. I guess one needs to read the underlying paper.

    Private default by insolvency resolution mechanisms (personal, corporate and banking) is very costly and disruptive when compared to devaluation + inflation. Default on, or restructuring of, public debt default is not as costly relative to the amount of money at stake.

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