I always venture with trepidation into the world of economics, no doubt still scarred by my sixth form brush with the economics teacher from hell, whose idea of insightful comment was “10% is 10%”, and who once walked out of a classroom in mid sentence, his voice slowly fading away down the corridor, without anyone feeling they had missed out on anything remotely profound. Still, when economics crosses paths with tax, I have to take my courage in both hands and blog.

 

The traditional answer to a deep economic crisis was for a country to devalue its currency. At a stroke exports become more competitive and imports become prohibitively expensive, with beneficial effects on domestic employment and demand, and the economic recovery has started.

 

All well and good in a world where each country had its own currency, but not terribly useful for countries in the Euro zone, which cannot devalue their currency unilaterally. Thus Portugal, Greece, Spain and Italy, together with that lesser known Mediterranean country, Ireland, need to find an alternative solution to their economic woes.

 

One possibility is a series of tax changes that mimic the impact of currency devaluation without one actually taking place, referred to as a fiscal devaluation. The basic steps are as follows:

 

  1. Cut taxes paid by employers, which in practical terms means social security contributions. The idea is to allow employers to reduce prices without imposing pay cuts, thus making them more competitive both domestically (thus reducing imports) and internationally (thus increasing exports).
  2. Increase VAT to recover the tax revenue lost at 1. The burden of this falls disproportionately on importers, who do not obtain the benefit of step 1 in compensation. This has a further impact on the level of imports, as the general price of goods in the economy rises.

 

The effect is not usually as dramatic as currency devaluation, but fiscal devaluation does have some noticeable beneficial effects on domestic economies. Of course it would not work if all of the Euro zone countries did it at the same time, so it needs to be reserved for the economic basket cases of the zone, as named above. Unfortunately no one told Germany this before it went for its own fiscal devaluation in 2007, although they probably wouldn’t have listened anyway.

 

Of course all of this is not without its problems, notably the disproportionate impact of a VAT rise on the poorer sections of society, who therefore need a significant degree of extra protection from government. But this could be one way of giving a boost to the Mediterranean economies without imperilling the cohesion of the Euro zone, and therefore appears to be worthy of serious consideration at this time of economic crisis.

 

Finally, it is interesting to view this in the light of UK government policy in the wake of the financial crisis, which appeared to consists of adopting step 2 without doing step 1 first; indeed national insurance rates were actually increased by the Labour government. Presumably the did not therefore feel that we were in need of a fiscal devaluation, perhaps because we retain our own free-floating currency, and the markets can therefore impose our devaluation for us.

 

 

 

 

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