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The Economics of a Reduction in VAT

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  • Ray Barrell

    ()

  • Martin Weale

    ()

Abstract

We explore the effects of a temporary cut in VAT, identifying three possible effects: an income effect as people benefit from a lower cost of living during the period of the reduction, a substitution effect as people bring their consumption forward and an arbitrage effect as people buy non-perishable goods before the end of the period of low VAT for consumption after the VAT rate as been raised. International evidence suggests a clear overall impact on consumption, although the nature of the pattern depends on the way in which the data are analysed. However, the key policy issue is the impact of the VAT change on output and to examine that a simulation model of the whole economy is needed. Evidence from the National Institute’s Global Economic Model suggests that the impact of the recent VAT reduction is likely to build up during the course of 2009. The reduction in VAT from 17 ½% to 15% is likely to result in consumption being augmented by less than 1 per cent by the fourth quarter of 2009. However GDP is likely to be raised raised by less than half a per cent relative to what would have happened without the VAT increase. After the temporary reduction is over both consumption and GDP are depressed as a result of the policy.

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Bibliographic Info

Paper provided by National Institute of Economic and Social Research in its series NIESR Discussion Papers with number 325.

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Date of creation: Mar 2009
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Handle: RePEc:nsr:niesrd:325

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Cited by:
  1. Jens Matthias Arnold & Bert Brys & Christopher Heady & Åsa Johansson & Cyrille Schwellnus & Laura Vartia, 2011. "Tax Policy for Economic Recovery and Growth," Economic Journal, Royal Economic Society, vol. 121(550), pages F59-F80, February.
  2. Gonzalo Fernandez-de-Cordoba & Jose L Torres, 2011. "The Transitory VAT Cut in the UK: A Dynamic General Equilibrium Analysis," Economic Issues Journal Articles, Economic Issues, vol. 16(1), pages 1-18, March.

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