Friday, 14 September 2012

Keep reasoning

A tale of mixing two policies

Policy 1: Fiscal consolidation (FC)

In his massive fiscal consolidation effort, the actual Portuguese Government had decreased public wages by suppressing the 13th and 14th months (called Summer and Christmas subsidies in Portugal). Later the Portuguese Constitutional Tribunal (TC) found that this was illegitimate because it went against the equity between private and public workers (!) and forced the government to give back one of the subsidies. 
The immediate implication would be an increase in public expenditure and a worsening of the deficit. 
To maintain the decrease in expenditure the Government decided to increase the social security contributions (ssc) paid by public employees by 7% (which is equal to 1/14). Consistently with the TC the increase in ssc is extended to all the workers (remember the private-public equity).

transition to…

Policy 2: Fiscal devaluation (FD)

Now you find yourself with an increase in 7% of the ssc paid by private employees which allows you to decrease social security paid by all firms by 5.5% (assuming public employees are 15%-20% of total employees). 
The willingness to maintain the decrease in public expenditure, and avoid a further increase in the deficit created the room for a fiscal devaluation. A "creative" FD as this is not what was suggested in previous studies/posts. My preliminary bird-eye view is that 

- in the long run total TSU has increased, therefore the labor-wedge has increased. The increase is small, 1.5%, but goes in the wrong direction, augmenting the labor market distortion.

- in the short run, the efficacy on competitiveness crucially depends on which wage is rigid: the net nominal wage (take home) or  the nominal wage gross of social security. In the original version of the FD (with VAT), when the decrease in TSU paid by employers decrease, the nominal take home wage is assumed not to increase which allows the gain in competitiveness. In this version of the FD, the nominal take home wage decreases because of the increase in ssc paid by employees. 

There are other differences between the FD with VAT and SSC paid by employees. Especially on the negative impact of demand. I am not going to tackle them here. I will underline the need to introduce some progressivity in the TSU.

At present Portugal needs to maintain its calm, avoid precipitous decisions and present clear-minded scenarios together with policies and their trade-offs.


1 comment:

  1. Francesco, thank you for the extremely nice reasoning presented in this post. I have a question that is constructed directly from what you mentioned here. In the original version of the FD that was presented previously one of the key aspects (due to VAT) was exactly that the take home wage is assumed not to increase. But in fact, if I understood clearly, in nominal terms (excluding the increase in the VAT for consumption purposes) it shouldn't decrease and created incentives for people not to consume that much and so, to increase aggregate savings. With the new policy the take home wage in fact decreased.

    Given this, do you think that this policy will be efficient and can it sustain some competitive gains in the medium run, after the labour unions react to this and start renegotiating the wages? And, how costly can it be in terms of labour market distortion when we look to the differences in the bargaining power of these labour unions (for extreme examples: the airline pilots) with those that are in the public service and cannot renegotiate their own contract?