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

• Published date: 01 May 2019
• DOI: http://doi.org/10.1111/roie.12393
• Date: 01 May 2019

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wileyonlinelibrary.com/journal/roie Rev Int Econ. 2019;27:694–710.

© 2019 John Wiley & Sons Ltd

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INTRODUCTION

By joining the monetary union, individual countries of the Euro area gave up the possibility of nomi-

nal exchange rate adjustment. Consequently, the external competitiveness of Euro area member states,

as measured by their real exchange rates, depended strongly on wage and price developments. After

the outbreak of the economic crisis in 2008, correcting large trade imbalances within the euro area

became one of the policy priorities, but the wage and price adjustments in the trade deficit member

states, that is, internal devaluation, often turned out to be very slow for several reasons, including the

fact that employers often choose to reduce employment, rather than to fully adjust wages, in order to

cut labor costs (IMF, 2012, 2015). The layoffs cause increasing unemployment, leading to a reduction

of trade imbalances through a decline in demand, rather than through real exchange rate depreciation

(IMF, 2012). Although eventually the trade imbalances within the euro area were largely resolved, this

often came at the cost of prolonged recessions that caused undesirable social consequences.

Received: 24 November 2017

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Revised: 4 September 2018

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Accepted: 7 January 2019

DOI: 10.1111/roie.12393

ORIGINAL ARTICLE

Fiscal devaluation and real exchange rates in the

Euro area: Some econometric insights

MarinaTkalec1

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MaruškaVizek1

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GoranVukšić2

1The Institute of Economics,, Zagreb, Croatia

2Institute of Public Finance, Zagreb, Croatia

Correspondence

Goran Vukšić, Institute of Public Finance,

Smičiklasova 21, 10000 Zagreb, Croatia.

Email: goran.vuksic@ijf.hr

Funding information

This study was supported by the Croatian

Science Foundation (Grant No. 7017).

Abstract

We explore whether a fiscal devaluation, that is, a reduc-

tion in employers’ social security contributions and an in-

crease 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’ contribu-

tions depreciate real exchange rates based on unit labor

costs, while value added tax hikes appreciate real ex-

change 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.

JEL CLASSIFICATION

F42, F45, H20

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695

TKALEC ET AL.

In the context of speeding up the required rebalancing process, the idea of using taxes as a tool to

restore competitiveness emerged: essentially, in order to achieve faster trade balance improvements

in the presence of nominal wage and price rigidities, countries should implement fiscal devaluations,

that is, shift a part of the tax burden from labor to consumption taxation (in a budget‐neutral way, as

usually assumed). The most widely discussed and analyzed form of such a tax shift involves cutting

the employers’ social security contributions, while increasing the value added tax. Fiscal devaluations

are expected to affect trade balances (at least partly) through real exchange rates (De Mooij & Keen,

2013; Farhi, Gopinath, & Itskhoki, 2014). If a part of the tax burden on labor is reduced, this may lead

to a reduction in labor costs and, other things equal, depreciation of the real exchange rate deflated by

unit labor costs. If the labor cost reduction is passed on to consumer prices, then the real exchange rate

deflated by the consumer prices should depreciate as well. Similarly, an increase in value added tax,

if it is at least partially passed on to consumers, would increase the overall price level and appreciate

the real exchange rate deflated by the consumer price index.

In this study we analyze the impact of fiscal devaluation on two bilateral real exchange rates

indicators in euro area countries—based on unit labor costs and on consumer prices. Thus, we

explicitly test for the specific channel of influence of fiscal devaluation on the trade balance via the real

exchange rates. The relevance of this channel has so far only been assumed, but not explored, in the

empirical studies of fiscal devaluation impact on the trade balance (De Mooij & Keen, 2013; Holzner,

Tkalec, Vizek, & Vukšić, 2018). Moreover, by distinguishing between short‐run and long‐run effects

of taxation, we take a step further in our analysis, as compared with the existing econometric studies

on taxation and real exchange rates, which are rather scarce in the first place. Unlike similar studies,

we use tax rates as our tax variables, reducing the endogeneity problem potentially stemming from

simultaneous shocks to dependent and tax variables, if the latter were expressed in terms of revenue

shares in GDP or shares in any other aggregate quantities (such as tax base proxies). We are also able

to mitigate potential policy endogeneity, that is, the fact that policy changes may be caused by devel-

opments in aggregate economic variables, such as the trade balance, since we examine the bilateral

real exchange rates. The bilateral approach also ensures more variability in the tax variables of interest

and takes into account the developments of relevant variables elsewhere, including the possibility of

policy coincidence, that is, simultaneous tax changes in other countries.

Besides being relevant for the specific policy‐related context of the euro area, our study also rep-

resents a contribution to more general empirical literature on the determinants of real exchange rates,

which has only rarely explicitly focused on the effects of individual taxation forms. The following

section describes the effects of employers’ social security contributions and value added tax on the

two measures of real exchange rate, as suggested in literature on fiscal devaluation. It then proceeds

to briefly present important concepts from the general research on real exchange rate determinants

and to provide a selective review of related studies explicitly examining the role of taxation, and of

studies dealing with the countries of the euro area. The third section then presents the data set and the

empirical approach. This is followed by the details of econometric strategy. The results are presented

in the fifth section, while the last section summarizes the results and concludes.

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RELATED RESEARCH

The research on fiscal devaluations, that is, the (budget‐neutral) tax shift from employers’ social

security contributions (SCR) to value added tax (VAT) implemented in order to improve countries’

external competitiveness, has largely been motivated by trade imbalances within the euro area, and

represents an attempt to clarify whether the rebalancing process can be accelerated using fiscal tools.