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| Fiscal
Spillovers in the Eurozone: Tax Increase versus Spending Cut |
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October-December 2006 |
In January 2007, Germany will experience a 3 percentage point increase in the VAT rate. This rise meets some of the stability and growth pact’s requirements and makes sense since the normal VAT rate in Germany (16%) lies 4 percentage points below the EU average (20%). However this is typically a major non-co-operative tax policy measure that may impact on consumption, GDP and prices not only in Germany, but in neighboring countries too.
A simple, Keynesian analysis would show that:
- Higher VAT will impact negatively on aggregate demand in Germany;
- Weaker demand in Germany will reduce GDP growth in neighboring countries through weaker exports.
This negative spillover could be reinforced through the monetary channel. This is because higher VAT in Germany will feed Eurozone inflation; hence the ECB may react through tighter monetary policy. To the extent that the increase in German prices remains one-shot (no second-round effects), neighboring countries will be unlikely to benefit from stronger competitiveness, in accordance with the fact that VAT is generally levied on the destination principle. On the whole, a negative spillover is expected for the Eurozone partners of Germany.
This view however can be challenged in several ways:
- First, the ECB may not react to the shock with monetary tightening. That could happen, for instance, if the fall in the output gap is large enough to prevent any second-round inflationary impact of the VAT hike.
- Second, German consumers may not react negatively to the shock. They may actually have anticipated this rise as unavoidable and, saved money accordingly. In addition German households may take the opportunity to smooth consumption over time with the help of the financial market.
These issues have recently been studied by the CEPII within the TAXBEN consortium, under the 6th Framework Program of the DG Research of the European Commission. This consortium aims at contributing to the understanding of the needs and functioning of tax/benefit reforms in the European Union. Within this consortium, the CEPII has been focusing on tax and social competition1 and on the short-term, macroeconomic impact of tax reforms.
On the theoretical side, a standard finding in the literature
is that, if the ECB aims at a 2% inflation rate for the aggregate Eurozone,
then a fiscal tightening in one country will generate positive spillovers
in other Eurozone countries. This occurs because the central bank will
cut interest rates until the inflation level and the output gap of the
zone as a whole are entirely stabilized. Bénassy-Quéré
(2006) shows that the size of a (positive) spillover may be lower for a tax increase
than for a spending cut, because in the first case the ECB will be less prone
to cut the interest rate. In addition, Benassy-Quéré argues that such an unrealistic positive spillover results
from a very strong reaction of the ECB. In the more realistic case of
interest-rate smoothing, the sign of the spillover becomes ambiguous and
depends on the relative strength of demand-side and supply-side effects.
If demand-side effects dominate, a tax increase in one country has a negative
impact on GDP of Euro partners; conversely, if supply-side effects prevail,
the same tax shock produces a positive impact on GDP in neighboring countries.
On the empirical side, it is important to pay attention
to the numerous structural changes that have affected the Euro area during
the last 40 years: financial liberalization, change in monetary policy
doctrine, monetary union… Hence, estimating domestic and cross-border
fiscal multipliers over such a long period may not be meaningful. Bénassy-Quéré
and Cimadomo (2006) estimate spending and tax multipliers within a VAR specification
over a rolling window of 17 years. The results for Germany are striking:
while a spending cut in Germany has no significant impact, a tax increase
impacts negatively on GDP in both Germany and neighboring countries.
However, both direct and cross tax multipliers seem to have decreased
since the launch of the monetary union. Following these results, the VAT
hike in Germany is expected to have a negative but moderate impact on
GDP in Germany and in its immediate neighboring countries.
1 - See The CEPII Newsletter No 26, 2005.
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BÉNASSY-QUÉRÉ, A., Short-Run Fiscal Spillovers in a Monetary Union, CEPII Working Paper No 2006-13, July 2006.
BÉNASSY-QUÉRÉ, A. & CIMADOMO, J., Changing Patterns
of Domestic and Cross-border Fiscal Multipliers, TAXBEN Working Document,
2006. |
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