Productivity Shocks, VAT Hikes and Emigration

Motivated by fiscal austerity and the surge in emigration in Europe’s periphery during the Great Recession Bandeira, Caballé and Vella study a particular type of fiscal consolidation: the one carried out through an increase in consumption tax rates. Using a small open economy model with search and matching frictions, endogenous migration and sticky prices, they find that VAT hikes induce a fall in consumption, which reduces labour demand and increases emigration. The departure of emigrants reinforces the fall in internal demand and employment, and therefore unemployment costs of VAT hikes over time can be higher than in an economy without migration. However, these effects are significantly smaller than in the case of labour income tax hikes. The authors also study the output and unemployment effects of negative productivity shocks in the presence of labour mobility