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The Transitory VAT Cut in the UK: A Dynamic General Equilibrium Analysis

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  • Gonzalo Fernandez-de-Cordoba
  • Jose L Torres

Abstract

This paper studies the macroeconomic effects of the transitory Value Added Tax (VAT) cut in the UK using a dynamic general equilibrium approach. The temporary VAT cut policy was announced on 24 November 2008, and was due to come into effect on 1 December 2008, with VAT reverting to its previous level as from 1 January 2010. We quantify the effects of that temporary fiscal stimulus policy on the key aggregate variables of the UK economy and on tax revenues. Overall, we obtain that this policy is too temporary to have important quantitative effects on the economy but qualitative effects are of great interest. We show that the temporary VAT cut will generate an overshooting effect on key macroeconomic variables, and will provoke a significant reduction in investment. Consumption and output will increase during the VAT cut, but they will decrease below their steady state values after VAT reverts to the previous level. Our model economy also predicts that fiscal revenues will decrease about three per cent during the VAT cut. Finally, we find that the VAT cut policy would have provided better results if it had been announced earlier.

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Bibliographic Info

Article provided by Economic Issues in its journal Economic Issues.

Volume (Year): 16 (2011)
Issue (Month): 1 (March)
Pages: 1-18

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Handle: RePEc:eis:articl:111afernandez

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  1. Baxter, Marianne & King, Robert G, 1993. "Fiscal Policy in General Equilibrium," American Economic Review, American Economic Association, vol. 83(3), pages 315-34, June.
  2. Thomas Crossley & Hamish Low & Matthew Wakefield, 2009. "The economics of a temporary VAT cut," IFS Working Papers W09/02, Institute for Fiscal Studies.
  3. David Carey & Josette Rabesona, 2002. "Tax Ratios on Labour and Capital Income and on Consumption," OECD Economic Studies, OECD Publishing, vol. 2002(2), pages 129-174.
  4. Jan-Ting Guo & Kevin J. Lansing, 1997. "Tax structure and welfare in a model of optimal fiscal policy," Economic Review, Federal Reserve Bank of Cleveland, issue Q I, pages 11-23.
  5. Glomm, Gerhard & Ravikumar, B., 1994. "Public investment in infrastructure in a simple growth model," Journal of Economic Dynamics and Control, Elsevier, vol. 18(6), pages 1173-1187, November.
  6. Richard Blundell, 2009. "Assessing the Temporary VAT Cut Policy in the UK," Fiscal Studies, Institute for Fiscal Studies, vol. 30(1), pages 31-38, 03.
  7. Ray Barrell & Martin Weale, 2009. "The Economics of a Reduction in VAT," NIESR Discussion Papers 325, National Institute of Economic and Social Research.
  8. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
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