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The Economics of a Reduction in VAT

Listed author(s):
  • Ray Barrell
  • Martin Weale

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 _% 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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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1475-5890.2009.00087.x
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Article provided by Institute for Fiscal Studies in its journal Fiscal Studies.

Volume (Year): 30 (2009)
Issue (Month): 1 (03)
Pages: 17-30

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Handle: RePEc:ifs:fistud:v:30:y:2009:i:1:p:17-30
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  1. Thomas F. Crossley & Hamish Low & Matthew Wakefield, 2009. "The Economics of a Temporary VAT Cut," Fiscal Studies, Institute for Fiscal Studies, vol. 30(1), pages 3-16, 03.
  2. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," The Quarterly Journal of Economics, Oxford University Press, vol. 117(4), pages 1329-1368.
  3. Campbell, John Y. & Mankiw, N. Gregory, 1991. "The response of consumption to income : A cross-country investigation," European Economic Review, Elsevier, vol. 35(4), pages 723-756, May.
  4. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 223-247, April.
  5. Weale, Martin, 1990. "Wealth constraints and consumer behaviour," Economic Modelling, Elsevier, vol. 7(2), pages 165-178, April.
  6. Ray Barrell & E. Philip Davis, 2007. "Financial Liberalisation, Consumption And Wealth Effects In Seven Oecd Countries," Scottish Journal of Political Economy, Scottish Economic Society, vol. 54(2), pages 254-267, 05.
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