Gavin R. Putland,  BE PhD

Sunday, July 07, 2013 (Comment)

Misrepresentation of ‘fiscal devaluation’ in the Weekend Australian

In an article headed “Fiscal devaluation key for competitiveness”, published in the Weekend Australian on 6 July 2013 (p.28), Jonathan Tolub of Van Eyk Australia correctly attributes the concept of fiscal devaluation to “among others, professor Gita Gopinath from Harvard University”.

Professor Gopinath, in the above Bloomberg TV interview, puts it in concrete terms: “So for instance a very simple prescription is to raise value-added taxes and cut payroll taxes. That swap — that simple tax swap — has pretty much the same effect as an exchange-rate devaluation would.

Farhi, Gopinath & Itskhoki, in the abstract of their paper “Fiscal Devaluations”, explain that “There are two types of fiscal policies equivalent to an exchange rate devaluation — one, a uniform increase in import tariff and export subsidy, and two, a value-added tax increase and a uniform payroll tax reduction.” To compensate for the effects of anticipation of the tax changes, “these policies need to be supplemented with a consumption tax reduction and an income tax increase.” Under the VAT-based policy, the result is a smaller increase in VAT and an income-tax rise, together with the usual cut in payroll tax. In footnote 5 (p.2), the authors add: “Further, under the tariff-based policy, an increase in income tax should extend to both wage income and dividend income, while under the VAT-based policy, the dividend-income tax should be left unchanged.” On p.4 they acknowledge that a cut in payroll tax must be matched by a cut in “capital taxes to firms” (company tax), in order to avoid substitution of labour for capital (which does not happen under an exchange-rate devaluation). Nowhere do they call for a cut in company tax without a matching cut in payroll tax.

The authors summarize their findings in an article in Project Syndicate, which emphasizes the cut in payroll tax and only implicitly mentions a cut in company tax.

But Tolub in the Weekend Australian redefines fiscal devaluation so as exclude any reduction in payroll tax. The photo caption in the online version (absent from the printed version) sets the agenda: “Lifting the GST rate will help lower corporate tax.” In the text, Tolub writes:

It [fiscal devaluation] involves raising a country's value added tax (VAT or GST) while simultaneously lowering its corporate taxes. Lifting GST will cause the consumer goods prices to rise, but lowering corporate tax allows local producers to reduce their cost base and put cheaper products on the shelves, thereby countering the effect of the tax hike.

Foreign producers won't get the benefits of the lower corporate taxes so imports will become more expensive than domestic products, thus attracting consumers [to domestic products].

Cutting payroll tax also reduces the cost base of local producers but not their foreign competitors. Moreover, cutting company tax reduces the cost base only in so far as the taxable profit represents the necessary return on capital, not economic rent. But the most “profitable” companies tend to be those whose “profits” are largely economic rent.

Tolub continues:

While cutting payroll taxes (a recent French idea) and lifting GST rates favour locally manufactured goods at the expense of imports, fiscal devaluation does so by making domestic manufacturers more competitive rather than penalising foreign ones, a subtle but key difference.

As such [sic], local goods will become more competitive not only in the home market but as exports as well. With high corporate tax levels, a low GST rate and a manufacturing sector in dire need of a competitiveness boost, Australia seems to be a prime candidate for fiscal devaluation.

As John Hewson's 1991 Fightback! package would have replaced payroll tax with GST, it's a bit rude to describe the idea as recent or to attribute it to the French, who in any case seem to have picked it up from Gopinath et al., whose original contribution is not the policy itself, but its equivalence with devaluation.

Be that as it may, Tolub's “subtle but key difference” is nonsense. A cut in domestic payroll tax does not penalize foreign producers any more than a cut in domestic company tax does. A cut in payroll tax, no less than a cut in company tax, makes local products cheaper in both domestic and foreign markets.

Australia is a “prime candidate for fiscal devaluation” chiefly because of the Superannuation Guarantee. A Federally mandated, employer-funded 9.25% super contribution is equivalent to a Federally funded 9.25% contribution paid for by a 9.25% Federal payroll tax — except that the employer-funded version is off-budget, making the Federal Government's fiscal footprint look smaller than it is. So the simplest way to implement a fiscal devaluation in Australia is to bring the Super Guarantee on-budget and fund it by an expanded GST instead of the present de-facto payroll tax.*

But why stop there? Gopinath et al., being academics, take pains to establish conditions under which a tax reform is exactly equivalent to a devaluation. But for practical purposes, exact equivalence is not necessary. In particular, in view of the high personal and social costs of unemployment, I see nothing wrong with a tax reform that yields a greater increase in the incentive to employ labour than in the incentive to employ capital, provided that both increase. (Tolub, in contrast, apparently sees nothing wrong with an incentive to substitute capital for labour.)

The cost of labour for employers can be reduced further — without reducing employees' take-home pay or widening after-tax wage inequalities — by replacing PAYG personal income tax by VAT 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 prices of domestic products.

Three advantages would follow. First, PAYG personal income tax would be completely removed from the marginal cost of labour as seen by employers, creating 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 would mean 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. In a more comprehensive version of the proposal, I have gone beyond Gopinath et al. by offering not merely a reduction in company tax, but the complete abolition of company tax (except on economic rent). I have called this version “internal devaluation by tax reform”.

But I thank Tolub for acquainting me with Farhi, Gopinath & Itskhoki. Until 6 July 2013, I had never heard of those authors or the expression “fiscal devaluation”. My own work on the subject known by that name has been independent.


* Update (4 September 2013): Alternatively, compulsory superannuation contributions and PAYG “personal” income tax could be offset against VAT; see my article “Fiscal devaluation on steroids” at MacroBusiness.

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