Gavin R. Putland,  BE PhD

Saturday, October 05, 2013 (Comment)

Maximalist ‘fiscal devaluations’ for Greece and Australia

Payroll tax is a reverse tariff: an inland payroll tax feeds into prices of locally produced goods and services, including those intended for export, but exempts imported goods and services up to the point of importation. In contrast, a Value-Added Tax (such as Australia's GST) is border-adjusted: it captures the value added to locally consumed goods and services, including the value added to imports up to and beyond the point of importation, but excludes exports. Hence, if payroll tax is replaced by VAT, exports become cheaper and imports become dearer.

Because this price effect resembles that of a currency devaluation, cutting payroll tax while raising VAT has become known as fiscal devaluation. But to call it that is to sell it short because it is not a zero-sum game. If every country substitutes VAT for payroll tax, every country untaxes domestic labour expended in capital formation, leading to more investment, hence faster growth.

Fiscal devaluation creates jobs by reducing the cost of labour for employers, with no reduction in workers' take-home wages and no widening of after-tax wage inequalities. Without the extra jobs, the tax switch would mean higher import prices but little change in prices of local products. With the extra jobs, it means less welfare spending and more consumption, hence less revenue to be raised from a bigger VAT base, so the required VAT rate allows a fall in prices of local products and a smaller rise in import prices. For working people, the effect on imports is a small price to pay for better earning opportunities and cheaper local products. Only those outside the workforce might need additional compensation for the rise in import prices, and only in the unlikely event that it outweighs the fall in prices of local products.

Supersized ‘fiscal devaluation’ for Greece

According to Cavallo and Cottani,

one of the reasons why labour costs are high in Greece is social security [payroll] taxes... 44% of gross wages, of which 28% is paid by the employer and 16% by the employee.

For Greece, Cavallo and Cottani recommended a fiscal devaluation big enough to eliminate payroll tax or, preferably, to let employers offset payroll tax against VAT (in other words, claim payroll tax as an input credit). The latter option removes payroll tax from the cost of labour, but otherwise leaves social security unchanged "while rewarding the firms that comply with their payroll tax obligations."

The "payroll tax" that the authors proposed to offset against VAT was the employer's 28% contribution to social security. But they could have gone further. The remaining 16% contribution, although attributed to the employee, is withheld from wages by the employer (IKA, p.2). The same is true of Pay-As-You-Go personal income tax. In employers' accounts, PAYG tax and employees' and employers' contributions to social security look much alike. All three are additions to the cost of labour, over and above what the employees can take home and spend. If all three were offset against VAT (subject to caps on the PAYG tax that can be simultaneously credited to non-arm's-length employees), and if the VAT rate were raised accordingly, the benefits would be similar in nature, but far greater in degree, than if only employers' contributions to social security were offset. Furthermore, because the offsets would encourage employers to pay workers in money rather than fringe benefits, there would be no need for separate taxation of fringe benefits.

Whenever it is claimed that a switch from personal income tax to VAT would raise prices, including prices of local products, it is assumed that the PAYG "personal" income tax presently withheld by employers would instead be paid out in wages and salaries and would therefore be unavailable to pay the VAT. No such problem arises if the withheld PAYG "personal" income tax is offset against, or credited towards, the VAT bill.

Application to Australia

In a country with a floating currency, such as Australia, the benefits of a fiscal devaluation would lead to a currency appreciation, causing a partial rollback of those benefits. The rollback is only partial because a complete rollback would take away the reason for the currency appreciation. So, although fiscal devaluation was invented as an escape from the constraints of a common currency or fixed exchange rate, it is still worth doing under a floating exchange rate.

The main Australian political parties have promised never ever to raise or broaden the GST. They have not promised never ever to replace the GST with a simple, border-adjusted Cash Flow Tax (effectively a VAT without tax invoices), as suggested in Chapter D of the Henry Report. Hence Australia could implement a maximalist fiscal devaluation by allowing employers to offset PAYG personal income tax and compulsory superannuation contributions against a suitably large Cash Flow Tax (CFT), and abolishing Fringe Benefits Tax.

Because superannuation contributions, being offset against CFT, would no longer add to the marginal cost of hiring any particular worker, superannuation could be made more equitable without pricing the beneficiaries out of a job. For example, your compulsory superannuation contribution could be a fixed amount per hour rather than a fixed percentage of your wage or salary.

So sue me

It could be argued that offsetting PAYG personal income tax against CFT (or GST) is a back-door method of border-adjusting an income tax, in contravention of free-trade rules. Any legal challenge on that ground could be short-circuited by exempting wages and salaries from income tax, and reinterpreting employment agreements and awards so that workers continue to receive the same after-tax pay. On paper, revenue received from employers as PAYG "personal" income tax would be replaced by revenue received from employers as CFT, and there would no longer be any income tax to border-adjust. In reality, nothing would change except that employers would no longer incur compliance costs in withholding and offsetting PAYG tax.

Similarly, any legal challenge to the offsetting of superannuation contributions against CFT could be short-circuited by funding the contributions directly from CFT revenue, cutting out employers. On paper, employers' contributions to superannuation would be replaced by government contributions. In reality, nothing would change except that employers would no longer incur compliance costs related to superannuation.

Legalities aside, these "short-circuiting" arrangements would reduce red tape for employers. In the long term, that is sufficient reason to recommend them. In the short term, the "offsetting" method would smooth the transition.


To implement a maximalist fiscal devaluation in Australia, we would replace the GST with a Cash Flow Tax, abolish FBT, and allow employers to offset withheld PAYG personal income tax and compulsory superannuation contributions against the CFT. While there would be no reduction in after-tax wages, and no widening of after-tax wage inequalities, the cost of labour for employers would fall, creating more jobs, hence more domestic demand for domestic products. As the CFT, unlike the cost of labour, would not feed into export prices, there would also be more foreign demand for domestic products, creating still more jobs. Without the new jobs, the required CFT rate would cause a rise in import prices but little change in prices of local products. With the new jobs, the required CFT rate would allow prices of local products to fall. The lowest-hanging fruit of tax reform has not yet been picked.


Last modified 6 Oct. 2013. Featured at Don't Mess With Taxes, 7 Oct. 2013. This post is a condensed version of "Fiscal devaluation on steroids", first published at MacroBusiness on 3 Sep. 2013. The original version includes an estimate of the required CFT rate.

Creative Commons License         Return to Contents
comments powered by Disqus