## 1. Fiscal Devaluation and Net Exports

## Source details

**Canonical URL:** [1. Fiscal Devaluation and Net Exports](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp1285.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp1285.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp1285.pdf.json)

---

### Introduction: fiscal challenge and growth imperative
- Context and objectives:
  - Aftermath of the financial crisis and sovereign debt tensions in advanced economies; need for substantial fiscal consolidation to reduce public debt and create space to address pension and health expenditure needs associated with aging.
  - Illustrative consolidation objective: reduce gross public debt to the lower of 60 percent or the pre-crisis level (and net debt to 80 percent of GDP in Japan).
- Projected public spending pressures:
  - Public healthcare spending in advanced countries projected to increase, on average, by about 3 percent of GDP over the next 20 years and by 6.5 percent over the next 40 years (IMF, 2010b).
  - Public pension costs expected to rise by 2.4 percent of GDP during the next 50 years in Europe (European Commission, 2009).
- Short-term tradeoff and country examples:
  - High unemployment and above-average fiscal deficits risk: rapid consolidation could impede recovery; slow adjustment risks market confidence and higher spreads.
  - Countries with above-average fiscal deficits and above-average unemployment: U.S., France, Portugal, Greece, Ireland, the Slovak Republic, and Spain.
  - Data refer to 2010, except for Ireland, where the projected deficit in 2011 is taken.

### Sectional agenda
- Section II: examine revenue-neutral tax shifts (notably from labor taxation/social contributions to VAT) to address competitiveness and employment.
- Section III: assess the merits of VAT strengthening/introduction for consolidation, growth and fairness; develop a methodology to diagnose VAT design and implementation weaknesses.
- Section IV: brief conclusions on fiscal devaluation and VAT reform.

---

### II. Fiscal Devaluation: concept, theory, and design issues

- Concept and mechanism:
  - Fiscal devaluation = reduction in the employer’s social contribution (SCR) combined with an increase in the VAT sufficient to at least preserve government revenue.
  - Rationale: reduction in SCR lowers producer labor costs (assumed fully passed into lower producer prices under contract specifications net of SCR), while higher VAT (a destination-based tax) raises relative consumer prices of imports and does not apply to exports.
  - Fiscal devaluation is not precisely equivalent to nominal exchange-rate depreciation; impacts vary across sectors and depend on wage and exchange-rate rigidity.
- Theoretical model (small, two-period open economy; key assumptions and results):
  - Labor supply inelastic at L̄; Period 1: fixed nominal wage W and employer tax τ_e (SCR) leads to employment condition w^d(P_1,L_1)+τ_e = W.
  - Employment response: L_1*(τ_e) = 1 / w^d_1 , so a cut in SCR increases employment in period 1.
  - VAT modeled as vector of specific taxes τ_c; consumer prices p = τ_c + P; revenues returned lump-sum but allow inefficiency parameter ζ (ζ ≥ 0).
  - Small-change comparative-static: ΔN = β_τe dτ_e + β_τc · dτ_c + β_ζ dζ (structure in Equation (2.5)).
    - β_τe: increase in τ_e tends to reduce period-1 net exports; larger effect the more elastic labor demand (see equation (2.6)).
    - β_τc: VAT changes affect net exports via first-period demand effects and indirect welfare-distortion effects (see equation (2.7)).
    - β_ζ ≥ 0: higher distortion from other taxes raises net exports via reduced demand (equation (2.8)).
- Special cases and unambiguous implications:
  - If VAT reform raises all consumer prices proportionally (dτ_c = γ p), then β_τc · dτ_c = 0; a uniform-rate VAT increase is equivalent to a lump-sum tax with no effect on net exports.
  - In that case, a cut in τ_e combined with a revenue-preserving uniform VAT increase yields ΔN > 0 driven solely by the τ_e cut.
- Caveats and design-sensitive features:
  - Introducing labor supply responsiveness, non-tradables, differential VAT rates, SCR ceilings, or contribution-benefit linkages can alter welfare and net-export dynamics.
  - Fiscal devaluation requires rigidity in exchange rate and nominal wages for competitiveness gains to materialize and persist; otherwise effects are temporary.
  - Practical effect depends on which VAT bases/rates are adjusted, treatment of non-tradables, demand elasticities, and labor-market rigidities.

---

### Empirical analysis: identification, methodology, and main findings

- Data and methodology:
  - Unbalanced panel of 30 OECD countries between 1965 and 2009.
  - Regressions in single-equation error-correction form with country and time fixed effects.
  - Key variables: N (net exports), SCR (employer social contribution), VAT, controls A (other tax revenue), Bal (government balance), DEP (dependency ratio), GROWTH (GDP growth), and sometimes UNEMPL.
  - Estimation methods: system GMM (Arellano and Bover (1995), Blundell and Bond (1998)) using both first-differenced and levels equations; fixed-effects with instruments; use of cyclically adjusted revenues and statutory rates as alternative measures.
  - Allow for differing responses by exchange rate regime (Eurozone vs. non-Eurozone) via interactions.
- Diagnostics and identification caveats:
  - Endogeneity concerns pervasive (tax revenue ratios may correlate with shocks to exports/employment).
  - Sargan, Hansen, and Arellano-Bond diagnostics vary across specifications; very high Hansen statistic in many cases pointing to weak instruments and potential finite sample bias.
  - Results sensitive to raw vs. cyclically adjusted data, inclusion of controls, choice of instruments, and use of statutory rates versus revenue shares.
- Main empirical results (selected highlights from Table 1 specifications):
  - Column (1) (raw revenue data, system GMM):
    - Eurozone: change in SCR and lagged SCR significantly negative for net exports; differenced VAT positive but far from significant.
    - Non-Eurozone: no significant effects.
    - Point estimate: a shift of one percent of GDP from SCR to VAT would increase net exports by 3.44 percent of GDP (significant at 5 percent).
  - Column (2) (cyclically adjusted revenue data, system GMM):
    - Change in SCR: larger negative and significant for Eurozone (1 percent level) and significant for non-euro (10 percent).
    - VAT generally insignificant.
    - Point estimates for short-run pure fiscal devaluation effect:
      - Eurozone: increase in net exports of 4.00 percent of GDP (significant at 1 percent).
      - Non-Eurozone: increase of 2.80 percent of GDP (significant at 10 percent).
    - Lagged net exports coefficients imply half-lives:
      - Eurozone: -0.10 (half-life 6.6 years).
      - Non-Eurozone: -0.21 (half-life 2.9 years).
    - Long-run impact in this column: no long-run effect in either group.
  - Column (4) (fixed effects, different instruments):
    - Differenced SCR coefficient much smaller; significant at 10 percent for Eurozone and 5 percent for non-euro.
    - Significant negative coefficient on lagged VAT in non-Eurozone.
    - Effects of fiscal devaluation insignificant in short and long run; F-test cannot reject equality across euro and non-euro.
  - Column (5) (statutory tax rates):
    - All tax effects insignificant except positive impact of differenced VAT in Eurozone.
    - Implied tax bases (from revenue shares and rates):
      - Implied VAT base in non-euro countries: 38 percent of GDP.
      - Implied SCR base in non-euro countries: 35 percent of GDP.
      - A shift from SCR to VAT by 1 percent of GDP would require raising the VAT rate by 2.5 percentage points and reducing the SCR rate by 2.9 percentage points (based on implied bases noted).
- Additional empirical findings (Table 2 / broader tax set):
  - Short-run ΔTax-coefficients (as presented):
    - SCR                                                              -1.74(1.14)
    - PIT                                                                -0.52(0.57)1.22                                                                (1.21)
    - CIT                                                                 1.44(0.86)3.18**                                                                 (1.64)
    - SCE                                                                0.89(1.69)2.64                                                                (1.82)
    - VAT                                                               0.81(1.69)2.56*                                                               (1.57)
  - Interpretations:
    - SCR shows a relatively strong negative effect on net exports (though not significant in this specification).
    - Financing an SCR reduction by higher VAT increases net exports by 2.56 percent of GDP (significant at 10 percent) in this specification.
    - Financing SCR reduction by higher CIT implies the largest short-term increase in net exports (but with likely subsequent reversals as investment income repatriates).
- Overall empirical interpretation:
  - Evidence suggests fiscal devaluation can increase net exports, particularly in Eurozone settings with fixed exchange-rate regimes; effects are generally temporary and sensitive to specification and instruments.
  - Point estimates indicate short-run increases in net exports from a 1 percent of GDP shift from SCR to VAT ranging between 1 and 4 percent of GDP in some specifications.
  - VAT effects often insignificant in short run consistent with theory when VAT increase is uniform; empirical insignificance notable given VAT heterogeneity in practice.

---

### III. The value and limits of the VAT in consolidation and C-efficiency decomposition

- Role of VAT in consolidation:
  - VAT strengthening/introduction is widely discussed as a consolidation option in Europe and for Japan and the U.S.
  - Strengthening the VAT would be required for countries aiming at substantial tax shifts along fiscal devaluation lines.
  - The paper develops a diagnostic methodology for VAT design and implementation weaknesses and applies it to identify less-distortionary, fairer reforms than raising already-high standard VAT rates.
- Decomposition of C-efficiency (Appendix IV):
  - C-efficiency decomposed into a “compliance gap” and a “policy gap”; policy gap further decomposed into rate differentiation and exemptions.
  - Independent estimates of all gaps not required: any one can be estimated as a residual given information on the others.
  - In practice, required information rarely available even within governments.
- Empirical illustration (Table 4, selected European countries, around 2005):
  - Main pattern: primary issue in most countries is design (policy gap) rather than implementation (compliance gap); Greece and Italy show much higher noncompliance.
  - Country-level figures reported exactly:
    - Austria: C-efficiency 61; Compliance gap 13; Policy gap 30; Rate differentiation 14; Exemptions 19
    - Belgium: C-efficiency 50; Compliance gap 12; Policy gap 43; Rate differentiation 19; Exemptions 30
    - Denmark: C-efficiency 63; Compliance gap 7; Policy gap 33; Rate differentiation 0; Exemptions 33
    - Finland: C-efficiency 60; Compliance gap 5; Policy gap 36; Rate differentiation 10; Exemptions 29
    - France: C-efficiency 51; Compliance gap 7; Policy gap 45; Rate differentiation 22; Exemptions 30
    - Germany: C-efficiency 54; Compliance gap 14; Policy gap 37; Rate differentiation 8; Exemptions 31
    - Greece: C-efficiency 44; Compliance gap 29; Policy gap 38; Rate differentiation 21; Exemptions 22
    - Ireland: C-efficiency 67; Compliance gap 4; Policy gap 30; Rate differentiation 28; Exemptions 3
    - Italy: C-efficiency 41; Compliance gap 27; Policy gap 44; Rate differentiation 25; Exemptions 26
    - Luxembourg: C-efficiency 89; Compliance gap 2; Policy gap 9; Rate differentiation 26; Exemptions -23
    - Netherlands: C-efficiency 58; Compliance gap 6; Policy gap 38; Rate differentiation 17; Exemptions 26
    - Portugal: C-efficiency 52; Compliance gap 8; Policy gap 43; Rate differentiation 22; Exemptions 27
    - Spain: C-efficiency 57; Compliance gap 8; Policy gap 38; Rate differentiation 32; Exemptions 10
    - Sweden: C-efficiency 55; Compliance gap 4; Policy gap 43; Rate differentiation 14; Exemptions 34
    - United Kingdom: C-efficiency 48; Compliance gap 15; Policy gap 44; Rate differentiation 22; Exemptions 28
  - Observations: significance of exemptions is striking; zero-rating of food and similar items can remove almost half of consumer spending from the VAT base in some cases.
- Obstacles to VAT reform:
  - Distributional concerns: VAT commonly perceived as regressive; assessing regressivity relative to current expenditure (rather than income) may yield different conclusions.
  - Rate differentiation: limited empirical grounds for confident differentiation; reduced rates for child care or certain labor-intensive services are minor cases.
  - Aggregate demand effects: pre-announcement can bring forward consumption (examples: Japan 1997, U.K. 2009), but lasting impact beyond timing likely small; firms can pre-adjust prices.
  - Political economy: resistance to base-broadening and removal of reduced/zero rates is deep; earmarking proceeds is politically useful but has public financial management costs.
- Empirical sample descriptive statistics (preserved exactly):
  - Net exports: No. obs 1241; Mean -.00; Std. Dev. 6.635; Minimum -34.681; Maximum 33.240
  - Gross Exports: No. obs 1241; Mean 35.99; Std. Dev. 22.84; Minimum 5.206; Maximum 179.77
  - Gov balance: No. obs 754; Mean -1.99; Std. Dev. 4.166; Minimum -15.593; Maximum 19.087
  - Total tax: No. obs 1248; Mean 32.44; Std. Dev. 8.898; Minimum 9.278; Maximum 52.246
  - Tax ex vat/scr: No. obs 1126; Mean 23.89; Std. Dev. 5.715; Minimum 7.964; Maximum 40.767
  - VAT base: No. obs 865; Mean 37.84; Std. Dev. 8.591; Minimum 0; Maximum 70.541
  - SCR base: No. obs 521; Mean 35.83; Std. Dev. 32.43; Minimum 10.957; Maximum 50.700
  - Revenue in percent of GDP:
    - PIT: No. obs 1177; Mean 9.370; Std. Dev. 4.848; Minimum 0; Maximum 26.545
    - CIT: No. obs 1080; Mean 2.518; Std. Dev. 1.672; Minimum -.463; Maximum 12.954
    - ESC: No. obs 1192; Mean 2.629; Std. Dev. 1.977; Minimum 0; Maximum 11.445
    - SCR: No. obs 1192; Mean 4.600; Std. Dev. 3.347; Minimum 0; Maximum 14.005
    - VAT: No. obs 1181; Mean 4.856; Std. Dev. 3.239; Minimum 0; Maximum 11.282
  - Cyclically adjusted series:
    - Government balance: No. obs 779; Mean -.107; Std. Dev. 2.963; Minimum -15.298; Maximum 7.4704
    - PIT: No. obs 732; Mean 11.24; Std. Dev. 5.127; Minimum 2.384; Maximum 29.181
    - CIT: No. obs 668; Mean 2.607; Std. Dev. 1.340; Minimum -.497; Maximum 6.5574
    - ESC: No. obs 715; Mean 3.380; Std. Dev. 2.125; Minimum 0; Maximum 11.878
    - SCR: No. obs 715; Mean 6.195; Std. Dev. 3.526; Minimum .0003; Maximum 14.219
    - VAT: No. obs 734; Mean 6.636; Std. Dev. 3.167; Minimum 0; Maximum 13.445
  - Statutory tax rates:
    - SCR rate: No. obs 583; Mean 22.38; Std. Dev. 12.270; Minimum .87; Maximum 51
    - VAT rate: No. obs 914; Mean 17.20; Std. Dev. 5.148; Minimum 3; Maximum 30
    - Average tax: No. obs 330; Mean 32.39; Std. Dev. 11.246; Minimum 7; Maximum 51.37
    - Marginal tax: No. obs 330; Mean 40.97; Std. Dev. 13.560; Minimum 7; Maximum 71.311
  - Other:
    - GDP growth: No. obs 1197; Mean 3.13; Std. Dev. 3.083; Minimum -11.615; Maximum 14.787
    - Dependency ratio: No. obs 1340; Mean 18.68; Std. Dev. 5.050; Minimum 5.596; Maximum 35.592
  - Additional summary points:
    - Statutory SCR rate varies between 0.9 percent and 51 percent, with an average of 22.38.
    - VAT rates vary from 3 to 30 percent, average 17.2 percent.
    - The PIT on average raises more than 9 percent of GDP. The VAT raises almost 5 percent of GDP, while SCR on average raises 4.6 percent of GDP.

---

### Policy implications, design guidance, and Box 1 insights

- Main policy messages on fiscal devaluation:
  - Revenue-neutral shifts from employers’ social contributions towards the VAT in Eurozone countries could improve the trade balance with sizable short-run effects, but effects disappear in the long run.
  - The case for such shifts rests on accelerating adjustment to deeper underlying problems; empirical evidence is suggestive but not fully robust.
- Design and equity considerations:
  - Distributional impacts: higher VAT reduces value to consumers of non-labor income and pensions; updating out-of-work benefits is important but raises fiscal costs.
  - Increasing reduced VAT rates (to protect poor households) dilutes revenue gains and reduces scope for SCR cuts.
  - Targeting SCR cuts (to new employment or small firms) can be more cost-effective but faces deadweight, displacement, perverse incentives, complexity, and low take-up.
- Box 1: targeting SCR cuts — summarized evidence and implications:
  - New-employment targeting drawbacks: deadweight if hires would have occurred anyway; displacement effects (studies report up to 65 percent); perverse incentives; high transaction costs; low take-up.
  - Small-firm targeting: evidence is mixed; small firms may not be the main source of net job growth once firm age is controlled for; young firms/start-ups drive job growth more than size per se.
  - Maintaining entitlement links when cutting SCR:
    - Options: decouple contributions and entitlements (move to tax-financed benefits) or preserve links via transfers/credits from general revenue (e.g., social security holiday).
  - Alternative revenue sources: residential property taxation noted as relatively growth-friendly with untapped potential.
  - International coordination: simultaneous fiscal devaluations by many countries reduce individual gains and raise competition concerns; shifting toward consumption taxation may nonetheless improve overall tax structure and growth prospects.
- Practical recommendations on VAT reform:
  - Favor base-broadening and uniformity under VAT on efficiency and distributional grounds unless strong evidence justifies specific reduced rates.
  - Use targeted compensatory measures to protect poor households (example: U.K. unifying rates while increasing social benefits left the three lowest income deciles better off and raised net revenue by about £11 billion).
  - Consider phased or carefully announced VAT adjustments to manage demand effects; evidence suggests pre-announcement mostly shifts timing of consumption.
  - In federations, explicitly design interaction between federal VAT and subnational sales taxes (VIVAT-like schemes) and avoid entrenching hard-to-reverse reduced rates.
  - If political acceptance requires earmarking, weigh pragmatic benefits against public financial management risks.
  - Use fiscal need and institutional commitment devices (where available) to focus reforms on base-broadening and implementation rather than further raising standard rates.

---

### Appendix IV: decomposition of C-efficiency (key points)
- C-efficiency decomposed into compliance gap and policy gap; policy gap further into rate differentiation and exemptions.
- Equations (3.2), (3.3), and related formulations show how these components aggregate and can be estimated in principle as residuals.
- Measurement caveats: required detailed information rarely available; different data sources produce divergent estimates (e.g., for the U.K. rate-dispersion vs. exemption effects).
- Policy implication: much VAT revenue potential in advanced economies comes from improving uniformity and coverage (reducing exemptions and rate differentiation) rather than solely from raising standard rates.

*Source: _wp1285 - 1. Fiscal Devaluation and Net Exports (IMF PDF content provided).*

### 1. Fiscal Devaluation and Net Exports ..................................................................................

### _wp1285 - 1. Fiscal Devaluation and Net Exports

### Introduction: fiscal challenge and growth imperative
- Context: aftermath of the financial crisis and sovereign debt tensions in advanced economies; need for substantial fiscal consolidation to reduce public debt and create space to address pension and health expenditure needs associated with aging.
- Illustrative consolidation objective shown: reduce gross public debt to the lower of 60 percent or the pre-crisis level (and net debt to 80 percent of GDP in Japan).
- Projected public spending pressures cited:
  - Public healthcare spending in advanced countries is projected to increase, on average, by about 3 percent of GDP over the next 20 years and by 6.5 percent over the next 40 years (IMF, 2010b).
  - Public pension costs are expected to rise by 2.4 percent of GDP during the next 50 years in Europe (European Commission, 2009).
- Short-term tradeoff: several countries face high unemployment and above-average fiscal deficits simultaneously, creating the risk that rapid consolidation could impede recovery while slow adjustment risks market confidence and higher spreads.
  - Countries identified with above-average fiscal deficits and above-average unemployment: U.S., France, Portugal, Greece, Ireland, the Slovak Republic, and Spain.
  - Note on data used in illustrative figure: Data refer to 2010, except for Ireland, where the projected deficit in 2011 is taken.

### Fiscal devaluation and revenue-neutral tax shifts (Section II overview)
- Purpose: examine the potential value and effectiveness of revenue-neutral tax shifts (notably shifts from labor taxation/social contributions to VAT) in addressing competitiveness and employment problems.
- Key premises and evidence cited:
  - Strong evidence that labor taxation is harmful for employment (references include Nickell and Layard, 1999; Bassanini and Duval, 2006; and OECD, 2011).
  - High labor costs seen as a structural problem in several troubled Eurozone countries; reduced labor costs viewed as a way to ease and accelerate adjustment.
  - Greece and Portugal ran trade deficits prior to their crises in the order of 11 percent of GDP.
- Policy practice and proposals:
  - In 2010, eight OECD countries reduced their social contribution rates for employers.
  - Prominent proposals in Europe for “fiscal devaluations” (also called “internal devaluations” or in France a “social VAT”): revenue-neutral (or revenue-enhancing) shift from social contributions to the VAT.
  - Examples: fiscal devaluation was a major element of Portugal’s initial arrangement with the IMF; France announced intent to undertake such a tax shift.
- Analytical agenda in Section II:
  - Explore theoretical case for tax shifts of this kind.
  - Provide an empirical analysis of whether and how these and other tax shifts might affect trade performance (presented as a novel contribution).
  - Discuss detailed design issues that arise in practice, including interactions with labor-market institutions and equity considerations.
- Central trade-off emphasized: cutting social contributions aids employment/competitiveness but runs counter to consolidation objectives and may be unaffordable in highly distressed countries.

### The value and limits of the VAT in consolidation (Section III overview)
- Rationale: VAT strengthening or introduction is seen as a key consolidation option in Europe and is widely discussed for Japan and the U.S.
- Purpose of Section III:
  - Assess the merits of the VAT in achieving consolidation, growth and fairness objectives.
  - Develop and begin to apply a methodology for diagnosing weaknesses in VAT design and implementation.
  - Identify reforms likely to be less distortionary and fairer than raising the standard VAT rate from already high levels in many countries.
- Framing: a strengthening of the VAT would be required for countries aiming at substantial tax shifts along the lines of a fiscal devaluation.

### Empirical and design considerations highlighted
- Interaction effects and subtleties:
  - The employment effects of labor taxation depend on interactions with labor-market institutions.
  - Design of tax shifts must consider distributional (equity) implications and potential offsets from revenue-raising measures.
- Analytical tools and materials included in the paper (listed in the source):
  - The paper contains empirical figures (including Figure 1: Fiscal Consolidation in Advanced Economies; Figure 2: Deficits and Unemployment in Advanced Economies) and appendices for derivations, separate regressions for Eurozone and non-Eurozone countries, data, and decomposition of C-efficiency.
- Boxed policy question highlighted:
  - Box 1: Should Social Contribution Cuts be Targeted on New Employment and Small Firms?

### Key statistics and illustrative facts (verbatim)
- Public healthcare spending projections: about 3 percent of GDP over the next 20 years and by 6.5 percent over the next 40 years.
- Public pension cost projection: 2.4 percent of GDP during the next 50 years in Europe.
- Pre-crisis trade deficits: Greece and Portugal ran trade deficits prior to their crises in the order of 11 percent of GDP.
- Policy action in 2010: eight OECD countries reduced their social contribution rates for employers.
- Debt-reduction illustrative target: reduce gross public debt to the lower of 60 percent or the pre-crisis level (and net debt to 80 percent of GDP in Japan).
- Countries with above-average deficits and unemployment (identified in Figure 2): U.S., France, Portugal, Greece, Ireland, the Slovak Republic, and Spain.
- Note on figure data timing: Data refer to 2010, except for Ireland, where the projected deficit in 2011 is taken.

*Source: _wp1285 - 1. Fiscal Devaluation and Net Exports (IMF PDF content provided).*

### Conclusions on these two issues are set out briefly in Section IV.

### _wp1285 - Conclusions on these two issues are set out briefly in Section IV.

### II. FISCAL DEVALUATION: TAX SHIFTS TO PROMOTE EMPLOYMENT AND COMPETITIVENESS — Overview
- Many countries implemented “job strategies” during the crisis including reductions in employer social contributions (“SCR” rates) and wage subsidy schemes.
- OECD Employment Outlook 2010: 12 countries expanded job subsidy programs in 2010, while another 8 reduced their SCR rates.
- Cutting SCR rates is revenue-losing in direct terms; the fiscal-devaluation concept asks whether revenue lost from SCR cuts can be preserved or increased by raising the VAT (or other destination-based taxes).
- Fiscal devaluation has been proposed as a policy option for Eurozone countries facing fiscal, unemployment, and competitiveness problems.

### A. Fiscal Devaluation: In Principle — Basic argument
- Historical and conceptual foundation:
  - Keynes (1931): import tariff + export subsidy mimics devaluation by raising domestic price of importables and reducing foreign price of exportables.
  - Shifting commodity taxation from an “origin” basis to a “destination” basis is essentially equivalent to an exchange rate devaluation: imports are brought into tax, exports taken out.
- Fiscal devaluation (classic European formulation):
  - Combine a reduction in the employer’s social contribution (SCR) with an increase in the VAT sufficient to at least preserve government revenue.
  - Focus on employers’ contribution reflects view that contracts are specified net of SCR; reduction in SCR is assumed fully passed into lower producer prices, lowering foreign-currency price of exports when the exchange rate is fixed.
  - Increased VAT, as a destination-based tax, does not apply to exports and applies equally to imports and domestically-produced goods sold at home, raising relative consumer prices of imports.
- Key implications and limitations:
  - Fiscal devaluation is not precisely equivalent to nominal exchange-rate depreciation (no change in foreign-currency value of domestic-currency assets; differing impacts across sectors reflecting labor intensity).
  - Effectiveness requires rigidity in both the exchange rate and the nominal wage:
    - With a flexible exchange rate, appreciation offsets competitiveness gains.
    - If domestic wages adjust upward in response to lower real wages (from higher VAT), the competitiveness effect dissipates in the long run.
  - Effects are likely temporary but may be important if they accelerate adjustment when economies are in marked disequilibrium (overvalued real exchange rate, high involuntary unemployment).
  - Temporary improvements can be politically and economically critical under a pegged exchange rate.

### A. Fiscal Devaluation: In Principle — A closer look (theoretical model and analytics)
- Model setup (small, two-period open economy; representative consumer):
  - Production revenue function R_t(P_t, L_t) homogeneous of degree one in N-vector of world prices P_t and labor L.
  - Discount rate = 0; present-value producer price vector: (P_1, P_2).
  - Labor supply in each period is inelastic at L̄.
  - Period 2: no labor taxation; labor market clears.
  - Period 1: fixed nominal wage W and tax τ_e (employer contribution, SCR) levied on top, yielding a price of labor above market-clearing rate w^d(P_t, L_t).
  - Employment in period 1 determined from: w^d(P_1,L_1)+τ_e = W. (Equation (2.1) as stated)
  - Employment response: L_1*(τ_e) = 1 / w^d_1  , implying a cut in SCR increases employment in period 1. (Equation (2.2))
  - VAT characterized as vector of specific taxes τ_c = (τ_c1, ..., τ_c2N); consumer prices fully flexible: p = τ_c + P.
  - Expenditure function e(p, U) and compensated demands c_i(p,U).
  - Revenues from SCR and VAT returned lump-sum to consumer.
  - Allow for an additional distorting lump-sum tax parameterized by ζ such that only fraction S_t is returned; ζ ≥ 0 captures inefficiency.
  - Consumer budget constraint summarized in equation (2.3) as given in the text.
  - Value at world prices of net exports in period 1 given by equation (2.4).
- Small-change comparative-static result for net exports (appendix result summarized):
  - ΔN = β_τe dτ_e + β_τc · dτ_c + β_ζ dζ. (Equation (2.5) structure)
  - Interpretation of coefficients:
    - β_τe (see equation (2.6)): involves the elasticity of labor demand; an increase in τ_e tends to reduce period-1 net exports, with larger effect the more elastic is labor demand.
    - β_τc (see equation (2.7)): VAT changes affect net exports via (i) direct first-period demand effects (through compensated demand matrix terms) and (ii) indirect welfare-distortion effects depending on marginal propensities to consume across periods and the demand structure.
    - β_ζ ≥ 0 (equation (2.8)): higher distortion from the “other” tax raises net exports via reduced demand; the magnitude depends on how much reduced expenditure occurs in period 1.
- Special cases and unambiguous results:
  - If VAT reform raises all consumer prices by same proportion (dτ_c = γ p, scalar γ), then β_τc · dτ_c = 0 because linear homogeneity of the expenditure function implies no effect on net exports; a uniform-rate VAT increase is equivalent to a lump-sum tax with no impact on net exports.
  - In the special case of a uniform VAT (or any reform that raises all consumer prices proportionately), a cut in τ_e combined with VAT increase that preserves revenue yields ΔN > 0 driven solely by the τ_e cut; fiscal devaluation increases period-1 net exports and is welfare-improving under the model assumptions.
- Caveats on model assumptions:
  - Analysis simplified by inelastic labor supply; introducing labor supply responsiveness (even to period-2 conditions) can change welfare and net-export dynamics (see footnote discussion).
  - If a small uniform-rate VAT is introduced in presence of pre-existing labor tax τ_e > 0, it can reduce labor supply in period 2 and lifetime welfare, lowering period-2 net exports and raising period-1 net exports via income effects.

### Other considerations (empirical and policy-relevant complexities)
- Non-tradables:
  - Tradables may be taxed more heavily under VAT than non-tradables (Feldstein and Krugman, 1990); nine EU Member States apply reduced rates to specified non-tradable labor-intensive services.
  - Higher standard VAT rate can reduce relative consumer price of non-tradables, encouraging substitution out of tradables; alternatively, if reduced VAT rates apply to tradables (e.g., zero-rated food in the U.K.), impact on net exports is ambiguous.
  - If non-tradable production is relatively labor-intensive, SCR cuts could disproportionately promote non-tradable production, limiting improvement in the trade balance.
- Complexity of VAT and SCR structures:
  - VATs are typically not a single uniform rate applied to all consumption; differential rates across goods/services affect the impact on net exports depending on compensated demand elasticities and intertemporal substitution.
  - Employer social contribution schemes are often more complex than a single parameter (e.g., contribution ceilings, linkage to future benefits), and incentive effects differ from a pure labor tax when contributions are tied to expected benefits (Disney, 2004).
- Design implications:
  - The practical effect of fiscal devaluation hinges on design details (which VAT bases/rates are adjusted, treatment of non-tradables, structure of SCR), demand elasticities, and labor-market rigidities.
  - Revenue-neutral VAT increases are not generically neutral for net exports unless implemented as a proportional uniform-rate increase across all consumer prices.

*Source: _wp1285 - Conclusions on these two issues are set out briefly in Section IV.*

### Section III discusses in more detail the differential economic effects of changes in standard VAT rates,

### _wp1285 - Section III discusses in more detail the differential economic effects of changes in standard VAT rates,

### Timing, compliance, and behavioral responses
- A permanent VAT increase announced well in advance may induce households to bring consumption forward, potentially producing temporary adverse effects on net exports (experiences recounted in Section III.C).
- A VAT increase implemented instantaneously and announced as temporary may lead consumers to postpone consumption, reinforcing improvement in the current account.
- Tax compliance is generally correlated with tax rates:
  - Increases in the standard VAT rate may exacerbate tax evasion and avoidance.
  - Lower SCR rates may improve compliance.
- Net impact of compliance changes is not a priori clear and likely varies with countries’ circumstances and administrative capacity; greater non-compliance in the VAT may be especially problematic where the standard VAT rate is already high and capacity to collect taxes other than by withholding is weak.

### Alternative tax instruments and generality of effects
- The VAT is not the only way to recoup revenue lost by a cut in SCR without necessarily offsetting the impact on net exports; broadly, any tax that does not directly affect labor costs would have the same effect (examples: excises on consumption of particular commodities, taxes on residential property).
- A wide range of taxes potentially affect net exports; theoretical effects can be complex (example: corporate income tax as discussed in Keen and Syed, 2006).
- The broader question: how the full range of tax instruments may affect export performance.

### Empirical literature and identification issues
- Little empirical evidence exists specifically on trade impacts of fiscal devaluation or tax reforms on trade.
- Related findings:
  - Poterba et al. (1986): nominal rigidities are important, supporting assumptions behind fiscal devaluation.
  - Alesina and Perotti (1997): labor tax variables increase unit labor costs in a panel of OECD countries; effect significant only with intermediate wage bargaining.
  - Lane and Perotti (1998 and 2003): estimated net export equations but looked only at total labor taxes, not consumption taxes.
  - Keen and Syed (2006): structure between corporate taxes and the VAT matters significantly for the trade balance in the short run (did not include social contributions).
  - Franco (2011): VARs for Portugal simulate impact of SCR reduction offset by VAT increase on exports and imports.
- Endogeneity concerns are pervasive:
  - Ratio of actual tax revenue to GDP may be correlated with the error term (e.g., export demand shocks lowering employment and social contributions).
  - Mitigation strategies used:
    - Inclusion of GDP growth as control.
    - System GMM (Arellano and Bover (1995), Blundell and Bond (1998)) using both first-differenced and levels equations; standard VAT rate and marginal SCR rate used as external instruments.
    - Use of cyclically adjusted revenue data from OECD Economic Outlook.
    - Fixed-effects regressions with GDP growth instrumented by its lag.
    - Use of statutory tax rates as alternative to revenues (trades off endogeneity vs. capturing bases and nonstandard rates).

### Methodology employed
- Regressions estimated in single-equation error-correction form (equation (2.9) in text), with country and time fixed effects (ߙ
௜
 and ߛ
௧
).
- Key variables:
  - N: net exports.
  - SCR: employer’s social contribution (variously measured).
  - VAT: value-added tax (variously measured).
  - Controls in X: revenue from other taxes (A), government balance (Bal), dependency ratio (DEP), GDP growth (GROWTH), and in some regressions, unemployment (UNEMPL).
- Allow responses to differ by exchange rate regime; distinguish Eurozone membership vs. non-Eurozone by interacting SCR, VAT, and lagged dependent variable with dummy indicators.
- Two measures of tax variables:
  - Shares of SCR and VAT revenues in GDP (actual or cyclically adjusted).
  - Statutory rates of SCR and VAT.
- Short-run impact of an increase in tax variable k given by coefficient on the differenced tax variable (ߚ
஽௞
); long-run impact given by lagged tax coefficient relative to lagged dependent variable (ߚ
௅௞
/ߣ).

### Key empirical results (Table 1 summary and computed effects)
- Dataset: unbalanced panel of 30 OECD countries between 1965 and 2009.
- Diagnostics:
  - Sargan test and Arellano-Bond statistic generally encouraging except for raw data in column (1) where Sargan test cannot reject over-identification.
  - Very high Hansen statistic in many cases, pointing to weak instruments and potential finite sample bias (Hansen falls noticeably below 1 in column (5)).
- Main patterns across specifications:
  - Column (1) (raw revenue data, system GMM):
    - For Eurozone: both the change in SCR and the lags of SCR show a significant negative impact on net exports; differenced VAT variable positive but far from significant.
    - For non-Eurozone: no significant effects emerge in change or lag.
    - Point estimate: fiscal devaluation short-run effect ߠ
ௌ
 implies a shift of one percent of GDP from SCR to VAT would increase net exports by 3.44 percent of GDP (statistically significant at 5 percent).
  - Column (2) (cyclically adjusted revenue data, system GMM):
    - Coefficient on change in SCR for Eurozone larger and significant at 1 percent; change in SCR also significantly negative for non-euro countries.
    - VAT remains generally insignificant.
    - Point estimates: short-run impact of pure fiscal devaluation:
      - Eurozone: increase in net exports of 4.00 percent of GDP (significant at 1 percent).
      - Non-Eurozone: increase of 2.80 percent of GDP (significant at 10 percent).
    - Lagged net exports coefficient:
      - Eurozone: -0.10 (implying half-life of 6.6 years).
      - Non-Eurozone: -0.21 (implying half-life of 2.9 years).
    - Long-run impact ߠ
௅
 indicates no long-run effect in either group in this column.
  - Column (3) (adds unemployment and interaction SCR×UNEMPL):
    - Interaction SCR×UNEMPL insignificant; qualitative results largely unchanged.
  - Column (4) (fixed effects with growth instrumented by lag; different instruments):
    - Coefficient on differenced SCR much smaller; significant at 10 percent for Eurozone, significant at 5 percent for non-euro.
    - Significant negative coefficient on lagged VAT in non-Eurozone.
    - Effects of fiscal devaluation insignificant in short and long run; F-test cannot reject equality of effects across euro and non-euro.
    - Suggests instruments matter greatly and endogeneity is a real issue; system GMM may better address it.
  - Column (5) (statutory tax rates; diagnostics supportive):
    - All tax effects insignificant except positive impact of differenced VAT in Eurozone.
    - Implied tax bases (computed from revenue shares and rates):
      - Implied VAT base in non-euro countries: 38 percent of GDP.
      - Implied SCR base in non-euro countries: 35 percent of GDP.
      - A shift from SCR to VAT by 1 percent of GDP would require raising the VAT rate by 2.5 percentage points and reducing the SCR rate by 2.9 percentage points (based on implied bases noted).

### Interpretation, dynamics, and policy-relevant magnitudes
- Evidence suggests fiscal devaluation (reducing employers’ social contributions and raising consumption taxes to keep government balance unchanged) can increase net exports, particularly in Eurozone countries:
  - Column (1) point estimate: 3.44 percent of GDP increase in net exports from a 1 percent of GDP shift from SCR to VAT (significant at 5 percent).
  - Column (2) point estimate: 4.00 percent of GDP increase for Eurozone (significant at 1 percent); 2.80 percent of GDP for non-Eurozone (significant at 10 percent).
- Time profile differs by regime:
  - Adjustment toward new equilibrium more sluggish in Eurozone (longer half-life), implying effects of fiscal devaluation persist longer in countries with fixed exchange rates.
  - Example half-lives reported:
    - Eurozone: 3.5 years (in one specification) and 6.6 years (in another specification).
    - Non-euro countries: 2.2 years (in one specification) and 2.9 years (in another specification).
- VAT effects are generally insignificant in short run across many specifications, consistent with theoretical prediction of small short-run impact of a uniform VAT increase; empirical insignificance is notable given heterogeneity of VATs in practice.
- Sensitivity to specification and instruments:
  - Results vary substantially with choice of raw vs. cyclically adjusted revenues, inclusion of controls, estimation method (system GMM vs. fixed effects), and use of tax rates versus revenue ratios.
  - Endogeneity and instrument strength remain important caveats; Hansen and Sargan statistics and Arellano-Bond diagnostics vary across columns.
- Overall implication: fiscal devaluation appears more likely to raise net exports in Eurozone settings with constrained nominal exchange rates, but magnitude and persistence are sensitive to empirical specification and endogeneity treatment.

*Italic attribution: Source: _wp1285 - Section III discusses in more detail the differential economic effects of changes in standard VAT rates,*

### 2.6 percentage points would be needed. The point estimates then imply that a fiscal

### _wp1285 - 2.6 percentage points would be needed. The point estimates then imply that a fiscal

### Key empirical findings on fiscal devaluation effects
- A fiscal devaluation in the Eurozone would generate a short-run increase in net exports of about 0.9 percent of GDP; this effect is significant at 10 percent.
- The estimated long-run effect on net exports is larger but statistically insignificant.
- Effects for non-Eurozone countries are of opposite sign, very small, and insignificant.
- The F-test rejects the null of equal effects between euro and non-eurozone countries, consistent with prior results, but when partitioning differently the effects are smaller and fiscal devaluation shows no effect outside the Eurozone.
- Some results imply a short-run increase in net exports from a shift of one percent of GDP ranging between 1 and 4 percent of GDP.
- There is reason to suppose that any effects of a fiscal devaluation will be temporary.

### Short-term effects of a wider range of taxes (Table 2 summary)
- Specification: estimation as in column (2) of Table 1, using cyclically adjusted data, no distinction between euro and non-euro coefficients; reported coefficients are for differenced tax variables (short-term impacts).
- Reported ΔTax-coefficient (as presented in source):
  - SCR                                                              -1.74(1.14)
  - PIT                                                                -0.52(0.57)1.22                                                                (1.21)
  - CIT                                                                 1.44(0.86)3.18**                                                                 (1.64)
  - SCE                                                                0.89(1.69)2.64                                                                (1.82)
  - VAT                                                               0.81(1.69)2.56*                                                               (1.57)
- Interpretations from Table 2:
  - The SCR term again shows a relatively strong negative effect on net exports, but it lacks significance in this specification.
  - The VAT coefficient is positive but insignificant in its own column; however, when used to finance a cut in SCR, a higher VAT increases net exports by 2.56 percent of GDP, with statistical significance of 10 percent.
  - Increases in PIT have an adverse effect on net exports, but less marked than SCR.
  - Coefficients on SCE and CIT are positive but insignificant in isolation.
  - Financing an SCR reduction by either a higher SCE or a higher PIT does not significantly increase net exports.
  - Financing the SCR cut by increased reliance on corporate taxation (CIT) implies the largest short-term increase in net exports; intuitively, higher CIT can induce a net outflow of capital abroad in the short run, which accompanies short-run increases in net exports, though these effects can be expected to reverse as income from investment abroad subsequently increases.

### Interpretation and caveats
- Results tend to confirm that, at least for Eurozone countries, domestic tax reforms can have significant effects on trade performance consistent with the theoretical predictions.
- Some empirical estimates are sizable, but effects appear temporary and may reverse over time.
- Empirical significance varies across specifications and tax instruments; conventional fiscal devaluation (SCR cut financed by higher VAT) appears effective for short-term net exports, but alternatives (notably CIT financing) may produce larger short-run effects with different dynamics and reversals.

### Policy implications
- Judicious tax shifts can have a noticeable impact on trade performance, but several important issues are not captured by the analytical framework:
  - Distributional impacts:
    - The increased VAT component of a fiscal devaluation reduces the value to consumers of non-labor income (transfers or capital income).
    - If out-of-work benefits are not updated to reflect increased VAT, many labor market models suggest a long-term fall in structural unemployment, implying stronger employment and output effects.
    - However, reduced real values of pensions and other social benefits raise equity concerns.
    - Increasing reduced VAT rates (often motivated by distributional concerns) may dilute revenue gains and thus reduce the achievable SCR cut and associated employment/labor supply gains.
    - The distributional impact depends on how the SCR cut is implemented (for example, whether upper limits on contributions are also reduced).
  - Targeting:
    - Across-the-board SCR cuts are expensive; more targeted measures may deliver a larger “bang-for-buck” in output and employment.
    - SCR relief targeted to low-wage earners may be particularly effective due to sensitivity of employment in this group to tax considerations and interactions with minimum wage constraints; this can reinforce impacts on employment, output, and the trade balance.
    - Common targeting approaches—relief for new employment and for small firms—are more problematic (discussion referenced in Box 1 in source).

*Source: Excerpt from content unit _wp1285 - 2.6 percentage points would be needed. The point estimates then imply that a fiscal*

### Box 1. Should Social Contribution Cuts be Targeted

### Box 1. Should Social Contribution Cuts be Targeted on New Employment and Small firms?

### Evidence on targeting cuts to "new" employment
- Intuitive appeal: limiting SCR (social contribution rate) cuts to “new” employment avoids revenue loss on inframarginal employees and maintains impact on producer prices to the extent marginal cost drives prices.
- Drawbacks and empirical findings:
  - Deadweight loss still arises if new employment would have occurred without the relief.
  - Displacement effects: newly hired employees may replace existing employees; some studies report these effects can be as large as 65 percent (Dahlberg and Forslund, 2005).
  - Perverse incentives: firms may lay off workers between announcement and the reference date used to measure increased employment.
  - High transaction costs and complexity: provisions needed to prevent enterprises relabelling themselves to count employment as “new.”
  - Low take-up rates, especially among smaller firms; U.S. state-level schemes show net employment effects that are positive but very small (Chirinko and Wilson (2011)).

### Evidence on targeting cuts to small firms
- Policy belief: small companies are widely believed by policy makers to be the main source of job growth; early evidence cited for the U.S. (Birch, 1987).
- More recent evidence questioning the small-firm focus:
  - Statistical and measurement issues require distinguishing gross versus net job creation (David et al., 1996).
  - Neumark et al. (2009) find that small firms contribute less to net job growth than large firms.
  - Haltiwanger et al. (2011) find that, once firm age is controlled for, there is no systematic relationship between firm size and employment growth in the US; job growth comes more than proportionally from young firms and start-ups.

### Maintaining entitlement links and financing options
- Payment-entitlement linkage:
  - Social contributions are generally linked—albeit often weakly—to entitlement to benefits.
  - If benefit values are to be maintained while SCR is cut, two options:
    - Decouple contributions and entitlements and move toward tax-based finance of social benefits; risk: worsening labor supply distortions if contributions are seen as forced savings (noted as advocated in the U.K. Mirrlees review28).
    - Maintain the link via transfers from general revenue to provide workers with explicit credits for the SCR not directly paid (example: social security holiday in the United States).
- Other tax instruments to recoup revenue:
  - Residential property taxation is noted as a possibility beyond those analyzed in Table 1 (excluded there due to lack of cyclically adjusted revenue data29).
  - Appeal of property taxation: little direct impact on production costs and some evidence it is relatively growth-friendly (Arnold, 2008); many countries have untapped revenue potential.

### International coordination and fiscal devaluation
- Coordination problem:
  - Fiscal devaluation could appeal to many countries simultaneously; if many undertake it, each country’s impact on net exports is diminished, raising concerns about competitive fiscal devaluations as international tax competition.
  - Difference from standard tax-competition harm: for fiscal devaluation the end-point is an increase in consumption taxation and reduction in labor taxation.
  - Empirical evidence (at least in the OECD) shows heavier reliance on consumption rather than income taxation is associated with faster growth (Kneller et al, 1999).
  - Therefore, even if fiscal devaluation has no effect on net exports, it may lead to an improved tax structure; downside is limited.

### Policy takeaway
- Targeting SCR cuts to new employment or to small firms has clear practical and empirical limitations: deadweight, displacement, perverse incentives, complexity, low take-up, and mixed evidence on small-firm contributions to net job growth.
- If SCR cuts are pursued while preserving benefit entitlements, policymakers must choose between decoupling entitlements (tax-financed) or preserving the link via explicit general-revenue transfers/credits.
- Revenue lost from SCR cuts can potentially be recouped from other bases—residential property taxation is highlighted as relatively growth-friendly and with untapped potential.
- While fiscal devaluation is not a substitute for structural reforms addressing wage rigidities, it can provide temporary mitigation and potentially improve national tax structures even if net-export effects are limited.

*Source: IMF Working Paper (Box 1 content).*

### Appendix IV that C-inefficiency can be decomposed as

### _wp1285 - Appendix IV that C-inefficiency can be decomposed as

### Decomposition of C-efficiency
- Equations (3.2) and (3.3) provide a decomposition of C-efficiency into a “compliance gap” and a “policy gap”.
  - The “compliance gap” reflects the difference between actual VAT collected and that theoretically due.
  - The “policy gap” relates to aspects of design and can be further decomposed into:
    - departures from a uniform rate structure (rate differentiation), and
    - the impact of exemptions.
- The equations have the convenient feature that independent estimates of all gaps are not needed: in principle, any one can be estimated as a residual given information on all the others.
- In practice, the information required to decompose C-efficiency in this way is rarely available. The text notes that even within government the needed information for this exercise is generally not available.

### Empirical illustration (Table 4): decomposition for selected European countries (around 2005)
- The table assembles disparate sources to illustrate the method. Key findings across countries:
  - Primary issue in most of these countries is design (policy gap) rather than implementation (compliance gap).
  - Some countries (notably Greece and Italy) show much higher noncompliance than peers.
  - The scope for improving uniformity and coverage of the VAT (rate structure and exemptions) stands out as the main source of revenue potential in many cases.
- Table 4 — country-level C-efficiency decomposition (as reported):
  - Austria: C-efficiency 61; Compliance gap 13; Policy gap 30; Rate differentiation 14; Exemptions 19
  - Belgium: C-efficiency 50; Compliance gap 12; Policy gap 43; Rate differentiation 19; Exemptions 30
  - Denmark: C-efficiency 63; Compliance gap 7; Policy gap 33; Rate differentiation 0; Exemptions 33
  - Finland: C-efficiency 60; Compliance gap 5; Policy gap 36; Rate differentiation 10; Exemptions 29
  - France: C-efficiency 51; Compliance gap 7; Policy gap 45; Rate differentiation 22; Exemptions 30
  - Germany: C-efficiency 54; Compliance gap 14; Policy gap 37; Rate differentiation 8; Exemptions 31
  - Greece: C-efficiency 44; Compliance gap 29; Policy gap 38; Rate differentiation 21; Exemptions 22
  - Ireland: C-efficiency 67; Compliance gap 4; Policy gap 30; Rate differentiation 28; Exemptions 3
  - Italy: C-efficiency 41; Compliance gap 27; Policy gap 44; Rate differentiation 25; Exemptions 26
  - Luxembourg: C-efficiency 89; Compliance gap 2; Policy gap 9; Rate differentiation 26; Exemptions -23
  - Netherlands: C-efficiency 58; Compliance gap 6; Policy gap 38; Rate differentiation 17; Exemptions 26
  - Portugal: C-efficiency 52; Compliance gap 8; Policy gap 43; Rate differentiation 22; Exemptions 27
  - Spain: C-efficiency 57; Compliance gap 8; Policy gap 38; Rate differentiation 32; Exemptions 10
  - Sweden: C-efficiency 55; Compliance gap 4; Policy gap 43; Rate differentiation 14; Exemptions 34
  - United Kingdom: C-efficiency 48; Compliance gap 15; Policy gap 44; Rate differentiation 22; Exemptions 28
- Sources noted in the original text for table inputs:
  - C-efficiency (for 2004) from Table 5.14 of European Commission (2011);
  - Compliance gap (for 2006) from Reckon (2009);
  - Rate differentiation from Table 5 of Mathis (2004).
- Observations on the decomposition:
  - The significance of exemptions (often calculated as a residual) is striking and sometimes surprising; in part this reflects estimated noncompliance that in many countries seems implausibly low.
  - Other estimates (for the U.K., for example) suggest statutory rate dispersion effect 48 percent and exemption effect 8 percent—differences that indicate the rate-structure calculations require closer evaluation.
  - Zero-rating of food and other items can take almost half of consumer spending out of the VAT base and is therefore crucial to revenue implications.

### Obstacles to VAT reform: Distributional issues and rate differentiation
- Perception: VAT is commonly seen as particularly regressive.
  - The text emphasizes that assessing regressivity relative to current expenditure (rather than current income) yields a different perspective because expenditure better reflects lifetime welfare.
  - The distributional effect of the tax-spending system as a whole matters most; advanced economies have better instruments (targeted transfers) to achieve distributional objectives than differential commodity taxation.
- Example: U.K. reform package (eliminating zero-and reduced rates, unifying at 17.5 percent while increasing social benefits).
  - The three lowest income deciles are winners from the package.
  - Revenue—net of increased social support costs—is increased by about £11 billion, which is around 14 percent of initial VAT revenue.
- Trade-offs and consequences:
  - Dealing with distributional implications may reduce net revenue available for consolidation.
  - In Japan, revenue gain from increasing the VAT rate would be reduced by automatic indexation of pension benefits.
  - Tightening targeting of social support to compensate poor households can raise marginal effective tax rates on earned income in the lowest deciles.
  - Rate differentiation may be justified on efficiency grounds only if an item is a substitute for untaxed work effort (in-home or market). Empirical evidence gives little reason for confident differentiation on these grounds.
  - Some arguments exist for reduced rates on items like child care and certain labor-intensive services, but these are minor; reduced rates in the EU have done little to increase compliance or employment.
- Policy implication:
  - The presumption for uniformity under the VAT is strong on both efficiency and distributional grounds.

### Obstacles to VAT reform: Aggregate demand effects
- Concern: raising the VAT (base or rate) could reduce aggregate demand, especially amid high unemployment.
- Evidence and counterarguments:
  - Pre-announcement of VAT increases tends to stimulate current consumption as consumers bring forward purchases (intertemporal substitution).
    - Ito and Mishkin (2006): before Japan increased its VAT rate in 1997 from 3 to 5 percent, consumers accelerated their spending in the preceding quarter by about 1.5 percent.
    - Crossley, Low, and Wakefield (2009) estimated a likely boost in consumer spending in 2009 of 1.25 percent associated with the U.K. temporary rate reduction from 17.5 to 15 percent.
    - German consumers anticipating a 3 percentage point VAT increase in 2007 brought forward their consumption by one year.
  - Firms can adapt pricing policies (Carare and Danninger (2008) show German firms increased prices before the actual VAT increase in 2006).
  - Any lasting impact on aggregate demand beyond the bringing forward of consumption is likely to be small.
    - In Japan, consumption picked up only one quarter after the 1997 tax increase; Cashin and Unayama (2011) find only a very modest impact on spending levels beyond the shift.
    - Other factors (e.g., the Asian financial crisis) played larger roles in downturns.
- Policy options to limit demand effects:
  - Accompany VAT reform with targeted protection of the poorest consumers (as in the U.K. example) to automatically limit the impact on those with highest marginal propensity to consume.
  - Some have proposed phased VAT increases to deliberately stimulate consumption (Feldstein (2002)); simulations suggest such effects are likely small and would not substantially accelerate exit from deflation (Auerbach and Obstfeld, 2004).

### Political economy
- Popular perception of VAT as inherently regressive persists and impedes both base-broadening in Europe and rate-raising in countries such as Japan and the U.S.
- Historical and recent country notes in the text:
  - Europe: significant changes have been made largely by raising the standard rate, tending if anything to reduce C-efficiency rather than increase it.
  - Japan and the United States: no changes had been made at the time of the writing (though Japan announced in January 2012 its intention to raise the VAT rate to 8 percent in 2014, and to 10 percent in 2015).
  - U.K.: the temporary reduction from 17.5 to 15 percent in 2009 was followed by a standard rate increase to 20 percent (January 2011).

*Source: Appendix IV, _wp1285 - Appendix IV that C-inefficiency can be decomposed as*

### introduction in Japan and the US, and fostering a willingness to deploy reduced rates. It

### _wp1285 - introduction in Japan and the US, and fostering a willingness to deploy reduced rates. It

### Resistance to VAT reform and political economy
- Resistance to broadening the VAT base and removing reduced/zero rates remains deep despite long-standing technical arguments in favor of reform.
- Possible reasons for resistance:
  - Costliness of supporting the poor through reduced rates may be used by politicians to signal concern for the vulnerable.
  - Credibility problems: consumers may doubt whether offsetting support through the tax-benefit system would be forthcoming or sustained.
- Technical point: mistakes in VAT design (for example, providing reduced rates on equity grounds) are extraordinarily hard to correct once entrenched.

### Earmarking proceeds as a political strategy
- Earmarking has been proposed to increase acceptability of VAT reforms:
  - Example proposals: earmarking VAT proceeds in the U.S. to healthcare costs (Burman (2009)); earmarking increased VAT proceeds in Japan to social security spending.
- Standard public financial management critique of earmarking:
  - Either it genuinely constrains spending on the favored item and impedes efficient resource allocation, or it does not constrain spending and risks misleading taxpayers (IFS, 1993).
- Empirical evidence (U.S. state data, Pérez (2008)):
  - Panel A of Figure 4: revenue is lower in states that earmark more.
  - Panel B of Figure 4: earmarking is more extensive where trust in the state government is higher.
- Conclusion on earmarking:
  - Understanding of causes and consequences of earmarking is limited.
  - Examples exist of harmful fragmentation through excessive earmarking (Korea).
  - Labeling can matter (example: Domenici-Rivlin Commission naming a proposed VAT a “Debt Reduction Sales Tax”).
  - If earmarking is the only way to overcome political resistance, it may be a pragmatic price worth paying.

### The disciplining role of fiscal need and EU commitment devices
- Dire fiscal need is a powerful force for overcoming resistance to deep VAT reform.
- Informal EU agreement on a maximum VAT rate can act as a commitment device: beyond some point, increased revenue needs will be met by base-broadening and improving implementation rather than raising the standard rate.

### Introducing a federal VAT in the United States: technical and political challenges
- A major challenge: determining the interaction between a federal VAT and existing state- and local-level sales taxes.
- Issues noted:
  - Converting state/local sales taxes into VATs seems natural but VAT is not well-suited to lower levels in federal systems because zero-rating of exports and taxing imports commonly relies on border controls not present within federations.
  - Other late adopters (Australia, India) are federal states; technical solutions exist (e.g., “VIVAT”).
  - VIVAT: all sales between registered businesses taxed at a common, federation-wide rate; lower levels add an additional charge for sales to final consumers (Keen (2001); McLure (2010)).
  - Massive variation in U.S. state/local sales tax bases and structures makes implementation difficult.
- Advantage for the U.S.: ability to avoid mistakes others have made and to learn from intellectual advances:
  - Example: bringing financial services more fully into the VAT is now understood in principle and may be more feasible in the U.S. than in the EU.
- Political lesson: avoid entrenching reduced rates that are hard to reverse.

### Empirical findings on fiscal devaluation and VAT as consolidation instrument (from conclusions)
- Fiscal devaluation:
  - Revenue-neutral shifts from employers’ social contributions towards the VAT in Eurozone countries could improve the trade balance, with quite sizable short-run effects.
  - Effects disappear in the long run; the case for such shifts rests on accelerating adjustment to deeper underlying problems.
  - Empirical evidence is suggestive but not entirely robust and subject to endogeneity concerns.
- VAT for fiscal consolidation:
  - A diagnostic tool is outlined to identify where scope for improvement lies, but the basic information needed to apply it is generally unavailable.
  - Many countries’ VAT systems appear to have considerable untapped potential, including advanced economies where a single-rate VAT on a broad base has a particularly strong case.
  - Overcoming persistent political resistance requires more than technically compelling arguments.

### Key statistics and empirical data (preserved exactly as reported)
- Panel findings referenced:
  - Figure 4: Panel A shows revenue is lower in states that earmark more; Panel B shows earmarking more extensive where trust in state government is higher.
- Sample descriptive statistics (Table 6; all figures preserved exactly):
  - Net exports: No. obs 1241; Mean -.00; Std. Dev. 6.635; Minimum -34.681; Maximum 33.240
  - Gross Exports: No. obs 1241; Mean 35.99; Std. Dev. 22.84; Minimum 5.206; Maximum 179.77
  - Gov balance: No. obs 754; Mean -1.99; Std. Dev. 4.166; Minimum -15.593; Maximum 19.087
  - Total tax: No. obs 1248; Mean 32.44; Std. Dev. 8.898; Minimum 9.278; Maximum 52.246
  - Tax ex vat/scr: No. obs 1126; Mean 23.89; Std. Dev. 5.715; Minimum 7.964; Maximum 40.767
  - VAT base: No. obs 865; Mean 37.84; Std. Dev. 8.591; Minimum 0; Maximum 70.541
  - SCR base: No. obs 521; Mean 35.83; Std. Dev. 32.43; Minimum 10.957; Maximum 50.700
  - Revenue in percent of GDP:
    - PIT: No. obs 1177; Mean 9.370; Std. Dev. 4.848; Minimum 0; Maximum 26.545
    - CIT: No. obs 1080; Mean 2.518; Std. Dev. 1.672; Minimum -.463; Maximum 12.954
    - ESC: No. obs 1192; Mean 2.629; Std. Dev. 1.977; Minimum 0; Maximum 11.445
    - SCR: No. obs 1192; Mean 4.600; Std. Dev. 3.347; Minimum 0; Maximum 14.005
    - VAT: No. obs 1181; Mean 4.856; Std. Dev. 3.239; Minimum 0; Maximum 11.282
  - Cyclically adjusted series:
    - Government balance: No. obs 779; Mean -.107; Std. Dev. 2.963; Minimum -15.298; Maximum 7.4704
    - PIT: No. obs 732; Mean 11.24; Std. Dev. 5.127; Minimum 2.384; Maximum 29.181
    - CIT: No. obs 668; Mean 2.607; Std. Dev. 1.340; Minimum -.497; Maximum 6.5574
    - ESC: No. obs 715; Mean 3.380; Std. Dev. 2.125; Minimum 0; Maximum 11.878
    - SCR: No. obs 715; Mean 6.195; Std. Dev. 3.526; Minimum .0003; Maximum 14.219
    - VAT: No. obs 734; Mean 6.636; Std. Dev. 3.167; Minimum 0; Maximum 13.445
  - Statutory tax rates:
    - SCR rate: No. obs 583; Mean 22.38; Std. Dev. 12.270; Minimum .87; Maximum 51
    - VAT rate: No. obs 914; Mean 17.20; Std. Dev. 5.148; Minimum 3; Maximum 30
    - Average tax: No. obs 330; Mean 32.39; Std. Dev. 11.246; Minimum 7; Maximum 51.37
    - Marginal tax: No. obs 330; Mean 40.97; Std. Dev. 13.560; Minimum 7; Maximum 71.311
  - Other:
    - GDP growth: No. obs 1197; Mean 3.13; Std. Dev. 3.083; Minimum -11.615; Maximum 14.787
    - Dependency ratio: No. obs 1340; Mean 18.68; Std. Dev. 5.050; Minimum 5.596; Maximum 35.592
- Additional summary points from text:
  - The statutory SCR rate varies between 0.9 percent and 51 percent, with an average of 22.38.
  - VAT rates vary from 3 to 30 percent, while the average is 17.2 percent.
  - The PIT on average raises more than 9 percent of GDP. The VAT raises almost 5 percent of GDP, while SCR on average raises 4.6 percent of GDP.

### Policy implications and recommendations
- When considering VAT reform:
  - Recognize political economy constraints: technical arguments alone may not suffice to secure reform.
  - Consider credible, packaged reforms that combine base-broadening with clearly specified compensatory measures; credibility may require institutional or labeling devices.
  - If political acceptance requires earmarking, weigh its pragmatic benefits against public financial management costs and risks of fragmentation.
  - In federations, explicitly design mechanisms for interaction between federal VAT and subnational sales taxes (options include VIVAT-like schemes), mindful of operational complexity given heterogeneous state/local tax bases.
  - Avoid entrenching hard-to-reverse reduced rates; favor design choices that remain reversible or that minimize long-term distortions.
  - Use fiscal need and commitment devices (where available) to focus increases on base-broadening and implementation rather than further raising standard rates.

*Italic line: Source: content derived from the provided PDF chapter/section (_wp1285) as supplied.*

### Appendix IV. Decomposing C-efficiency

### Appendix IV. Decomposing C-efficiency

### Definitions and notation
- Denote by ܥ
௜ and ܥ
௜
כ respectively the values of the true consumption of commodity i and the part that is brought into tax; the difference between the two being imperfect implementation.
- Denote by ܶ
௜ and ܶ
௜
כ the statutory and effective rates of tax on final consumption of i, the latter reflecting not only tax levied directly on i but also indirect effects through exemptions on intermediate inputs (mediated by the input-outputs structure, as described for instance in Ebrill et al (2001)).
- Total revenue is written as ∑ܶ
௜
כܥ
௜
כ
௜.

### Decomposition and key equations
- Equations (3.2) and (3.3) follow from writing:

  ܧ
஼
ؠ
∑
ܶ
௜
כ
ܥ
௜
כ
௜
߬
௦
∑
ܥ
௜௜
ൌቆ
∑
ܶ
௜
כ
ܥ
௜
כ
௜
∑
ܶ
௜௜
ܥ
௜
כ
ቇቆ
∑
ܶ
௜
ܥ
௜
כ
௜
∑
ܶ
௜
ܥ
௜௜
ቇቆ
∑
ܶ
௜
ܥ
௜௜
߬
௦
∑
ܥ
௜௜
ቇ                             ሺܦ.1ሻ

- With the interpretation in the text given by:

  ؠݏ݊݋݅ݐ݌݉݁ݔܧ
  ∑
  ܶሺ
  ௜
  ܶെ
  ௜
  כ
  ܥሻ
  ௜
  כ
  ௜
  ∑
  ܶ
  ௜௜
  ܥ
  ௜
  כ
                                                    ሺܦ.2ሻ

  ؠ݌ܽ݃ ݈݁ܿ݊ܽ݅݌݉݋ܥ
  ∑
  ܶ
  ௜
  ܥሺ
  ௜
  ܥെ
  ௜
  כ
  ሻ
  ௜
  ∑
  ܶ
  ௜
  ܥ
  ௜௜
                                                    ሺܦ.3ሻ

- And:

  1െؠ ݊݋݅ݐܽ݅ݐ݊݁ݎ݂݂݁݅ܦ ݁ݐܴܽ
  ∑
  ܶ
  ௜
  ܥ
  ௜
  ௜
  ߬
  ௦
  ∑
  ܥ
  ௜
  ௜
  ೌ
  =
  ߬
  ௦
  ൌ
  ∑
  ܶ
  ௜
  ߱
  ௜௜
  ߬
  ௦
                         ሺܦ.4ሻ

- Where ߱
  ௜
  ؠ
  ஼
  ೔
  ∑
  ஼
  ೂ
  .

### Interpretation of components and measurement
- Impact of exemptions:
  - Measured by the loss of revenue from taxing at effective rather than statutory rates.
  - This impact may be negative because exempting intermediate transactions can produce a cascading effect that raises C-efficiency (an instance of poor design that leads to higher C-efficiency).

- Compliance gap:
  - Measured as the revenue loss (at nominal tax rates) from failing to bring some final consumption into tax.

- Rate differentiation effect:
  - Reflects the extent to which the weighted average VAT rate is lower than the standard rate.
  - Could in principle be negative.
  - Since ߬
  ௦
  ൌ
  ∑
  ܶ
  ௜
  ߱
  ௜௜
  ߬
  ௦
  ൌ
  ሺ
  ߬
  ௦
  ܧ
  ൌ
  ሾ
  ܶ
  ሿሻ
  ሻ߱,ܶሺݒ݋ܿ൅ is sure to be positive if reduced rates are prevalent (so that non-standard rates are on average lower than standard) and positively correlated with budget shares.

*Appendix IV. Decomposing C-efficiency*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp1285.pdf_