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April 01, 2012, Sunday

Fiscal devaluation for Turkey

Last Monday I was talking about fiscal devaluation in Southern Europe as a means of restoring competitive power. Then, a similar proposal arrived from Mehmet Şimşek, minister of finance. Last Wednesday he gave an interview to Ayşe Alp from the Hürriyet daily in which he suggested a fiscal devaluation for Turkey. Let me restate that fiscal devaluation means a reshaping of the tax structure, by increasing some taxes and decreasing some others, in order to give a push to the competitiveness of the economy.

Turkey, although being in an incomparable situation to Southern Europe regarding the public deficit and debt burden, is, however, suffering from weak competition. Indeed, the Turkish economy has relatively high labor costs given the average productivity level of its industry. Despite the 5 percentage point cut off in social security premium, implemented three years ago, Turkey is still placed at around the median among Organization for Economic Cooperation and Development (OECD) countries considering labor costs. This is putting Turkey well above its Eastern European competitors. To lower its huge current account deficit, Turkey needs to export more and import less along with increasing its low savings ratio. To do so, it needs to improve its competitiveness and encourage private savings. For this purpose fiscal devaluation could indeed be an efficient tool.

In his interview, Finance Minister Şimşek defined a tax reform strategy that I believe would be one of the most striking achievements of the Justice and Development Party (AK Party) government in the field of economic reforms, if of course it is implemented. But curiously the economic media did not pay the proposal the attention it deserves. Anyhow, this is the media's fault.

Mr. Şimşek's idea is to use the extra tax revenue that is expected from the planned income tax reform for a reduction in payroll taxes through an additional cutoff in social security premiums. Tax reform, already on the government's agenda, basically consists of fighting tax evasion, particularly widespread regarding income tax, through a simplification of the rules and efficient monitoring. If successful, the extra revenue can be spent either on current public expenditures or on public investments. Obviously, these are the most appealing options for a democratically elected government. But a third option also exists; use the extra revenue to lower labor costs. This is an option that can hardly be transferable directly into votes but it is, for sure, a much more judicious way to make the micro-adjustments that the Turkish economy needs.

This fiscal devaluation could allow the attainment of multiple goals. As it was pointed out by Minister Şimşek, lowering labor costs will likely reduce the number of informal workers, encourage corporations to hire more and give a push to the growth that is expected to slow remarkably this year. According to Labor Force surveys, one wage earner out of five is currently unreported to the Social Security Institution (SGK). And one can estimate that among the registered wage earners, still one out of five is underreported, in other words, his wage is not fully declared. Although it is not the unique cause of the informality, there is no doubt that high payroll taxes play a critical role in the choice of informality by the entrepreneurs. Payroll tax cutoffs would certainly reduce informality and, in this way, create extra revenue for the SGK.

Labor economic theory predicts that low labor costs means more labor in production even if this effect is often limited. In the times of sluggish growth and increased unemployment, which is the baseline scenario for the coming years, a push on employment, even a modest one, would be highly appreciated. However, the important impact will be on growth via the decrease of the huge current account deficit. Improvement of competitiveness will encourage exports as well as local production to substitute imported goods. Turkey absolutely needs to switch from its domestic, demand-led growth to a more balanced growth, if one wants a sustainable growth of around at least 5 percent.

To make the dream a reality, the Ministry of Finance should move to reveal, as soon as possible, its plan to fight tax evasion. If ministry inspectors are harsher, more extra revenue will be available and it will be more effective in dealing with the payroll tax cutoffs regarding the informality, employment and growth. But at the same time if more inspectors are tougher, more voters, the majority of them likely supporters of the AK Party, will get angry at this reform. Do not forget that political economy is the art of managing unpleasant trade-offs. But well-designed economic reforms always pay back in the long run.

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