On the Long-Term Impact of a Fiscal Devaluation: An Application to the Portuguese Case

We use a dynamic general equilibrium model to quantify the likely long-term impact of a fiscal devaluation on the Portuguese economy. In a context of exogenous growth, and imposing an unchanged budget deficit to GDP ratio in the year the policy is enacted, we find that a tax swap worth 1 percent of steady-state GDP raises long-term income by as much as 1 percent, and still contributes towards fiscal consolidation, provided there are no cost of living adjustments. This permanent GDP gain is the result of a shift to a broader tax base, with fewer distortions, that then induces a faster accumulation of private capital. If all beneficiaries of public transfers and all civil servants are fully compensated for the increase in VAT, then a tax swap of the same magnitude raises long-term income by only 0.7 percent, and public indebtedness is not significantly altered. We also find that larger fiscal devaluations yield less-than-proportional GDP gains. The fact that fiscal devaluations are rather disappointing in raising the level of GDP can be traced back to a small net reduction in the overall labor tax wedge. This suggests that policymakers need to look elsewhere in their quest for efficient tax reforms.