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Sticker Shocks: VAT changes and the substitution across expenditure categories

Author

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  • Bart Hobijn

    (Federal Reserve Bank of San Francisco)

  • Fernanda Nechio

    (Federal Reserve Bank of San Francisco)

Abstract

We take a quasi-experimental approach to estimate the value for the across-sector elasticity of substitution. To that end, we use the effects of changes in value added tax (VAT) rates on long-run movements in relative prices to identify the magnitude of the elasticity of substitution across expenditure categories. Using a standard model of imperfect competition with Cobb-Douglas production and Dixit-Stiglitz preferences both within and across sectors, we show that the long-run response of relative prices to changes in VAT is a simple function of the labor share and the elasticity of substitution across sectors. We construct a novel data set of VAT rate changes by expenditure categories in the European Union matched to their respective inflation rates. Estimates of the effect of VAT rate change on inflation in the long-run suggest that the magnitude of the elasticity of substitution across expenditure categories nears 3.

Suggested Citation

  • Bart Hobijn & Fernanda Nechio, 2015. "Sticker Shocks: VAT changes and the substitution across expenditure categories," 2015 Meeting Papers 697, Society for Economic Dynamics.
    • Handle: RePEc:red:sed015:697
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    References listed on IDEAS

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