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We quantitatively assess the macroeconomic implications of permanently reducing the public debt-to-gross domestic product (GDP) ratio in euro area countries. The simulations of a currency union dynamic general equilibrium model, calibrated to the euro area, give the following results. First, tax distortions are quantitatively significant. Second, the best fiscal consolidation strategy is to permanently reduce both expenditures and tax rates. Third, the transition is generally not costly, as the GDP and investment would grow, while private consumption would not fall. Finally, spillovers to the rest of the euro area are generally expansionary and .

In 2014 all ECB publications feature a motif taken from the €20 banknote.NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily refl ect those of the ECB. Sandra GomesBank of Portugal; e-mail: sandra.cristina.gomes@bportugal.pt Pascal JacquinotEuropean Central Bank; e-mail: pascal.jacquinot@ecb.int Massimiliano PisaniBank of Italy; e-mail: massimiliano.pisani@bancaditalia.it AbstractWe assess the effects on trade balance of a temporary fiscal devaluation enacted by Spain or Portugal by simulating EAGLE, a large-scale multi-country dynamic general equilibrium model of the euro area. Social contributions paid by firms are reduced by 1 percent of GDP for four years and are financed by increasing consumption tax. Our main results are the following. First, the Spanish trade balance improves by 0.5 percent of GDP, the (before-consumption tax) real exchange rate depreciates by 0.7 percent and the terms of trade deteriorate by 1 percent. Second, similar results are obtained in the case of Portugal. Third, the trade balance improves when the fiscal devaluation is enacted also in the rest of the euro area, albeit to a lower extent than in the case of unilateral (country-specific) implementation. Fourth, quantitative results crucially depend on the degree of substitutability between domestic and imported tradables. JEL Classification Numbers: F32; F47; H20.Keywords: fiscal devaluation; trade deficit; dynamic general equilibrium modeling. ECB Working Paper 1725, August 2014 1Non-technical Summary A country belonging to a monetary union cannot rely on nominal exchange rate devaluation to increase, in presence of nominal price rigidities, its international relative price competitiveness and, hence, improve in the short run its trade balance. An alternative way to increase the short-run international price competitiveness is through a temporary "fiscal devaluation", defined as the combination of two fiscal measures: the decrease in social contributions paid by employers and the increase in consumption tax.The reduction in employers' social contributions reduces the unit labor costs. As long as the latter are passed-through into final prices, the improvement in price competitiveness favors exports and reduces imports. The reduction in contributions is financed by increasing the consumption tax, which is also a destination-based tax. As such, it raises the after-tax price of domestic and imported goods uniformly, but not the price of exported goods. Overall, the combination of lower unit labor costs and higher consumption tax decreases the price of exported goods and increases the after-tax relative price of the imported good.In this paper we assess the trade balance improvement in correspondence of a tem- lower than in the case on unilateral devaluation, as tradable goods produced in the rest of the euro area are now more competitive than in the case of unilateral devaluation. Ex-

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