Fiscal devaluation on steroids

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Gavin R. Putland explains how “fiscal devaluation” can replace not only employers’ contributions to superannuation, but also PAYG personal income tax.

Payroll tax is a reverse tariff: an inland payroll tax feeds into prices of locally produced goods and services, including those intended for export, but exempts imported goods and services up to the point of importation. In contrast, a Value-Added Tax (such as Australia’s GST) is border-adjusted so that it captures the value added to locally consumed goods and services, including the value added to imports up to and beyond the point of importation, but excludes exports. Hence, if payroll tax is replaced by VAT in a revenue-neutral manner, exports become cheaper and imports become dearer, while local prices of local products (on average) stay about the same.

Because this price effect resembles that of a currency devaluation, cutting payroll tax while raising VAT has become known as fiscal devaluation. But to call it that is to sell it short because, unlike currency devaluation, it is not a zero-sum game. If every country devalues its currency by the same fraction, none of them does; the effects cancel out. But if every country substitutes VAT for payroll tax, every country untaxes domestic labour expended in capital formation, leading to more investment, hence faster growth, hence (in the long term) more capacity to consume.

Fiscal devaluation creates jobs by reducing the cost of labour for employers, with no reduction in workers’ take-home wages and no widening after-tax wage inequalities. Without the extra jobs, the tax switch would mean higher import prices but little change in prices of local products. With the extra jobs, it means less welfare spending and more consumption, hence less revenue to be raised from a bigger VAT base, so the required VAT rate allows a fall in prices of local products and a smaller rise in import prices. For working people, the effect on imports is a small price to pay for better earning opportunities and cheaper local products. Only those outside the workforce might need additional compensation for the rise in import prices, and only in the unlikely event that it outweighs the fall in prices of local products. In a positive-sum game, there doesn’t need to be a loser.


Fiscal devaluation redistributes the impact of taxation between factors of production so as to reduce the damage. If we tax the value of labour, there will be less labour. If we tax the value of (produced) capital, there will be less capital. But if we tax the value of land, there will not be less land. (For present purposes we may take land to mean not only “location, location”, but all assets that taxpayers cannot create or destroy or move, including government-granted privileges.) Thus the tax system will be most conducive to production if it targets only the value of land. Cutting payroll tax, which targets only the value of labour, is a step in that direction. A VAT, which targets the price of consumption, is indifferent to whether that price is received as, or paid by, the return to labour, capital or land. This indifference, though not as good as targeting land alone, is better than targeting labour alone.

The reasons why currency devaluation is zero-sum, while fiscal devaluation is not, may be seen in the further tax adjustments that are needed to turn fiscal devaluation into an exact replica of currency devaluation. According to the wonkish mathematics of Farhi, Gopinath & Itskhoki (PDF), these adjustments include higher taxation of labour income and a reduction of “capital taxes to firms”. The former is destructive. The latter is constructive only in so far as “capital taxes” fall on produced capital, not land; but the authors make no such distinction. The reduction in “capital taxes” avoids “an incentive to substitute labor for capital, an effect absent under a nominal devaluation.” When youth unemployment in Greece approaches 65% (as at May 2013), and when we Australians consider a 5% official unemployment rate — corresponding to a double-digit real rate — to be about as good as it gets, it is not obvious that an incentive to substitute labour for “capital” is altogether evil, especially when the labour so favoured includes that expended in the formation of capital.

Proponents of fiscal devaluation therefore do well when they focus on payroll tax and VAT rather than strive for a closer imitation of currency devaluation. But they could do even better.


Supersize me!

According to Gopinath et al.,

From 1996 to 2010, unit labor costs in Germany increased by just 8%, and by 13% in France. Compare that to 24% in Portugal, 35% in Spain, 37% in Italy, and a whopping 59% in Greece.


In 2010, Cavallo and Cottani offered a partial explanation:

In our opinion, one of the reasons why labour costs are high in Greece is social security taxes… 44% of gross wages, of which 28% is paid by the employer and 16% by the employee.

For Greece, instead of an exit from the eurozone, Cavallo and Cottani recommended a fiscal devaluation big enough to eliminate payroll tax or, preferably, to let employers offset payroll tax against VAT (in other words, claim payroll tax as an input credit). The latter option removes payroll tax from the cost of labour, but otherwise leaves social security unchanged “while rewarding the firms that comply with their payroll tax obligations.”


The “payroll tax” that the authors proposed to offset against VAT was the employer’s 28% contribution to social security. Here I suggest that the authors missed a trick. The remaining 16% contribution, although attributed to the employee, is withheld from wages by the employer (IKA, p.2). The same is true of Pay-As-You-Go personal income tax. In employers’ accounts, PAYG tax and employees’ and employers’ contributions to social security look much alike. All three are additions to the cost of labour, over and above what the employees can take home and spend. If all three were offset against VAT (subject to caps on the PAYG tax that can be simultaneously credited to non-arm’s-length employees), and if the VAT rate were raised accordingly, the benefits would be similar in nature, but far greater in degree, than if only employers’ contributions to social security were offset. Furthermore, because the offsets would encourage employers to pay workers in money rather than fringe benefits, there would be no need for separate taxation of fringe benefits.

Whenever it is claimed that a switch from personal income tax to VAT would raise prices, including prices of local products, it is assumed that the PAYG “personal” income tax presently withheld by employers would instead be paid out in wages and salaries and would therefore be unavailable to pay the VAT. No such problem arises if the withheld PAYG personal income tax is offset against, or credited towards, the VAT bill; the withheld PAYG tax is effectively rebadged as VAT before it leaves the hands of employers. That is what would happen under my maximalist form of fiscal devaluation.

Application to Australia


In a country with a floating currency, such as Australia, the benefits of a fiscal devaluation would lead to a currency appreciation, causing a partial rollback of those benefits. The rollback is only partial because a complete rollback would take away the reason for the currency appreciation. Moreover, because a fiscal devaluation does not (and should not) exactly imitate a currency devaluation, it cannot be exactly compensated by a currency appreciation. So, although fiscal devaluation was invented as an escape from the constraints of a common currency or fixed exchange rate, it is still worth doing under a floating exchange rate.

The main Australian political parties have promised never ever to raise or broaden the GST. They have not promised never ever to replace the GST with a simple, border-adjusted Cash Flow Tax (effectively a VAT without tax invoices), as suggested in Chapter D of the Henry Report. Hence Australia could implement a maximalist fiscal devaluation by allowing employers to offset PAYG personal income tax and compulsory superannuation contributions against a suitably large Cash Flow Tax (CFT), and abolishing Fringe Benefits Tax.

Because superannuation contributions, being offset against CFT, would no longer add to the marginal cost of hiring any particular worker, superannuation could be made more equitable without pricing the beneficiaries out of a job. For example, your compulsory superannuation contribution could be a fixed amount per hour rather than a fixed percentage of your wage or salary.


So sue me

It could be argued that offsetting PAYG personal income tax against CFT (or GST) is a back-door method of border-adjusting an income tax, in contravention of free-trade rules. Any legal challenge on that ground could be short-circuited by exempting wages and salaries from income tax, and reinterpreting employment agreements and awards so that workers continue to receive the same after-tax pay. In law and on paper, revenue received from employers as PAYG “personal” income tax would be replaced by revenue received from employers as CFT, and there would no longer be any income tax to border-adjust. In reality, nothing would change except that employers would no longer incur compliance costs in withholding and offsetting PAYG tax.

Similarly, any legal challenge to the offsetting of superannuation contributions against CFT should be short-circuited by funding the contributions directly from CFT revenue, cutting out employers. In law and on paper, employers’ contributions to superannuation would be replaced by government contributions. In reality, nothing would change except that employers would no longer incur compliance costs related to superannuation.


Legalities aside, these “short-circuiting” arrangements would reduce red tape for employers. In the long term, that is sufficient reason to recommend them. In the short term, the “offsetting” method would smooth the transition.

Show us the numbers

In 2011-12, according to ABS 5506.0, Australia collected $154 billion in personal income tax and FBT, and $49 billion in GST; and according to ABS 5204.0 (Table 6), wages and salaries amounted to $632 billion, on which a 9.25% superannuation contribution would have yielded about $58.5 billion. That gives a total of $261.5 billion in revenue to be replaced by, or offset against, the CFT. In the same year, according to the following year’s Budget Papers (PDF), Australia spent about $7.5 billion on unemployment benefits and about $14.5 billion on Disability Support Pension. If we suppose that the expansion of job opportunities would eliminate $5 billion of unemployment benefits and $6.5 billion of DSP, the revenue requirement comes down to $250 billion. This is still pessimistic (too high) because it includes personal income tax not captured by the PAYG system, and does not allow for higher company-tax receipts due to expansion of business.


The CFT base is tax-inclusive consumption, including government consumption (because governments, not being CFT payers, would not claim CFT deductions on purchases). In 2011-12, Australia collected $49 billion in GST. At a tax-exclusive rate of 10%, the tax-exclusive base was $490 billion. Dividing this by a VAT revenue ratio of 0.49 (OECD, 2011, p.40), we estimate the potential tax-exclusive consumption base as $1 trillion, to which we add the actual revenue to obtain a tax-inclusive base of $1.049 trillion. Allowing for additional consumption due to additional employment, we can reasonably increase this by about 10%, to $1.15 trillion. On that base, the desired $250 billion in revenue would require a CFT rate of about 22%.


To implement a maximalist fiscal devaluation in Australia, we would replace the GST with a Cash Flow Tax, abolish FBT, and allow employers to offset withheld PAYG personal income tax and compulsory superannuation contributions against the CFT. While there would be no reduction in after-tax wages, and no widening of after-tax wage inequalities, the cost of labour for employers would fall, creating more jobs, hence more domestic demand for domestic products. As the CFT, unlike the cost of labour, would not feed into export prices, there would also be more foreign demand for domestic products, creating still more jobs. Without the new jobs, the required CFT rate would cause a rise in import prices but little change in prices of local products. With the new jobs, the required CFT rate would allow prices of local products to fall. The lowest-hanging fruit of tax reform has not yet been picked.


(I thank my colleagues at Prosper Australia for their comments on drafts of this article. Responsibility for the final content is my own.)

About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.