Fiscal devaluation and real exchange rates in the Euro area: Some econometric insights

Abstract

We explore whether a fiscal devaluation, that is, a reduction in employers’ social security contributions and an increase in value added tax, affects two indicators of bilateral real exchange rates in the euro area: one based on unit labor costs, and another based on consumer prices. We find that, in the short term, cuts in employers’ contributions depreciate real exchange rates based on unit labor costs, while value added tax hikes appreciate real exchange rates based on consumer prices. In the long run, a value added tax increase also appreciates the real exchange rates based on unit labor costs.

Composition of trade flows and the effectiveness of fiscal devaluation

“…Our results remain largely unchanged also if bilateral real exchange rate based on consumer prices is controlled for: we omit it from our specifications following De Mooij and Keen (), as we consider the impact of taxes that should, at least partly, affect trade balances through real exchange rate changes. The effect of tax changes on real exchange rates, as suggested in the fiscal devaluation literature, has been empirically confirmed by Tkalec, Vizek, and Vukšić ().…”

Fiscal devaluation and relative prices: evidence from the Euro area

“…However, even if an extensive literature has investigated the economic determinants of both the TOT and the REER (Corsetti et al 2007;Monacelli and Perotti 2008;Galstyan and Lane 2009;Griffoli et al 2015), only a few papers have focused on the relationship between specific taxes and relative prices (Alesina and Perotti 1995; Freund and Gagnon 2017), and little is known on the potential impact of a fiscal devaluation. Tkalec et al (2019) studied the impact of both VAT and SSCs' tax changes on the real exchange rate, but do not specifically analyse a revenue-neutral tax shift. To the best of our knowledge, no paper has ever analysed the effects of a fiscal devaluation on the relative price of tradables (TOT), though this should perhaps be more important since theory suggests that the trade balance should mainly be affected by the reduction in the relative price of domestic tradable goods.…”