Yes, Greece could devalue (while staying in the euro) | FT Alphaville

Yes, Greece could devalue (while staying in the euro)

An eye-catching headline from UBS.

On Wednesday, economist Stephane Deo explains how Greece could use a sort of proxy for currency devaluation — the erm, traditional answer to debt overloads — to help haul its way out of crisis.

He calls it ‘social VAT.’ Here’s how it works:

Most of the financing cost of social security is supported by taxes on labour. Depending on the country, the largest proportion of these taxes is levied on employers or on employees. The result is the same: the cost of labour is increased. This creates an unwanted side-effect: internationally exposed sectors are made less competitive as their total labour cost rises in proportion to the taxes on labour. The idea is thus to move the tax base towards consumption – i.e. to use VAT to finance the social accounts. Hence the name “social VAT”.

This has the advantage of reducing the cost of labour, but also has the advantage of taxing imports, which is a way to shift part of the burden abroad. Finally, the tax base is very broad (about two-thirds of GDP comes from consumption) – so any increase in VAT is very efficient in terms of government receipts.

This is very much akin to devaluation. The point of devaluation is to make exports more competitive. Economists usually argue that the best proxy of country competitiveness is its exchange rate adjusted for labour costs. To be more precise, we usually look at the effective exchange rate deflated by unit labour costs. The idea is thus simple: instead of adjusting the exchange rate, the adjustment is provided by a cut in labour costs, or more precisely the tax component of the labour cost.

The point of devaluation is also to reduce imports. “Social VAT” achieves that in two ways. First, imposing a higher VAT rate will increase the price of imported goods. But devaluation also changes the relative price of imported goods versus domestic goods, which is not the case with a uniform rise in VAT. The idea, once again, is that – as the increase in VAT is compensated for by a cut in social contributions – the cost of production of domestic goods will be reduced, and their price compared to imported goods will thus be reduced. The relative price argument is valid here as well.

Sound far-fetched? Deo says it’s already happened, notably in Denmark in 1987, in Germany during 2007, and most recently, in Hungary three years ago. All of the countries have increased VAT rates to partly or fully finance cuts in social security, he says, hence the nomer ‘social VAT reform.’

In fact, you could argue that this is something of a eurozone trend — the below charts show the historical tax structure in the EMU and what looks like a shift in the composition of the tax base:

When it comes to Greece, however, some of this has already done. In fact one half of it has — Greece upped VAT twice last tear, shifting the main rate from 19 to 23 per cent. But it didn’t do the other half of social VAT reform — it didn’t cut social security contributions.

And according to Deo, Greece is “definitely not in a position now to cut social security taxes.”

All of which means, of course, that while Greece could devalue using social VAT, it’s probably very unlikely to do so now. Instead that adjustment in labour costs will come through a very painful cut in wages, Deo says, and most ominously, a “forthcoming sharp increase in the unemployment rate.”


Related link:
Social VAT – Vivant Europe
Social VAT: Good or Bad Idea? – SSRN paper
Devaluation – the great Greek damp squib? – FT Alphaville