Tax Your Way Out Of Trouble!

"The upper class keeps all the money, pays none of the taxes.  The middle class pays all of the taxes, does all of the work.  The poor are there ... just to scare the sh@# out of the middle class.  Keep 'em showing up at those jobs." - George Carlin

Recently there has been a lot of interest in an internal devaluation strategy published by a Harvard University professor Gita Gopinath.  Her idea is to get the Euro zone out of its current debt crisis by changing the tax structure.  As I have explained in previous blogs, the way a country normally gets out of a debt spiral is by devaluing their currency.  A weak currency makes local industry more competitive and balances the trade imbalance.  It also creates local inflation as global imports become more expensive.  This inflation devalues the debt in real terms making it easier to afford the loan payments and hey presto, you are back in business!

The problem in the Euro zone is that there is no way to devalue your currency.  So for example if you are Greece, Spain or Italy and you have a mountain of debt your main option used to wiggle your way out of the mess has been taken from you.  When Turkey was in a hole they fixed their problem by weakening their currency, but Euro zone countries do not have that option.  They are tied together to one currency and that currency is being kept aloft by the strongest players, namely Germany and to a lesser extent France.

So the obvious answer is to leave the currency union but this would be catastrophic for all countries in the Euro zone for reasons too numerous to mention in this blog.  That is where Professor Gopinath's paper comes in; instead of devaluing the currency why not create a tax structure that does the same thing?  Her idea is to reduce payroll taxes and increase value-added taxes (VAT).  By decreasing payroll taxes the local worker automatically gets a raise and will spend the majority of that increase in their local country thereby stimulating the local economy.  Furthermore by putting in place a value-added tax the price of imports will be increased while exports would be proportionally cheaper as no VAT is added to exports.  A hybrid currency weakening or as it is called an internal devaluation strategy!

French President Francois Hollande proposed a similar plan when he recently presented his budget and other Euro zone countries are considering the idea.  So it is all systems go and Europe is fixed!  Not so fast.  First of all in any VAT scheme there will be the backlash of trade tariffs.  Essentially a country that adopts this strategy is placing a tariff on imports which may meet with resistance from trade partners.  Furthermore there is no guarantee that the VAT tax will offset the loss of payroll taxes and in countries such as France where social programs abound; cutting payroll taxes may create a bigger hole in the budget than there was before.  A bigger hole means more money needed to be borrowed and the spiral continues.  Finally if every country in the Euro zone took up this strategy the benefit becomes more and more diluted.

So while the idea has some merit I very much doubt that this is the solution to Europe's problems but it will be interesting to see how it works in France as one thing you can be sure of, everyone is trying to find a solution without cutting benefits and services and that is impossible.  Already we are seeing the impact of the automatic budget cuts in the United States and these are having a very real impact on the economy right at the time when weakness abounds.  Looks like it is back to the drawing board.