Working Paper Series no. 516: Strategic fiscal revaluation or devaluation: why does the labor wedge matter?

Abstract

Most European countries suffer from a structural weakness of employment and competitiveness. Can an optimal tax system reinforce European countries in this respect? If so, does this long-term policy act as a devaluation or a revaluation? In this paper, we show that fiscal devaluation can be an optimal policy only if the labor wedge is sufficiently large. Indeed, whereas the terms-of-trade externality calls for a fiscal revaluation, i.e. the use of tariffs by "strategic" countries for extracting a rent from their trade partners, a sufficiently large labor wedge calls for employment subsidies, at the heart of a fiscal devaluation. We show that these subsidies must be financed by VAT instead of tariffs, which are less efficient. Finally, in a multi-country world, we show that, if several countries adopt a similar strategy, the impact of this policy is magnified.

François Langot and Matthieu Lemoine
October 2014

Classification JEL : D51, F42, H21.

Keywords : Optimal taxation, international trade, labor wedge, general equilibrium model