Temporary VAT Reduction during the Lockdown

This paper evaluates the temporary VAT reduction introduced by the German government over the third and fourth quarter of 2020 as most controversial part of the COVID-19 stimulus package. Critics argue that VAT reductions are ineffective because of limited pass-through of temporary measures to consumer prices and in presence of lockdown measures. Advocates emphasize positive effects on durables and stress that a VAT reduction can at least partly substitute for a limited monetary policy response under the ZLB. We build a DSGE model which is capable to address these channels. Our model distinguishes between sectors directly and indirectly affected by the lockdown. This allows us to trace economic spillovers of lockdown measures to the rest of the economy and the differentiated impact of VAT measures on both sectors. We disaggregate consumption into durables and non-durables for both financially constrained and unconstrained households and we allow for imperfect pass-through of VAT measures into consumer prices. In general, if we include the durable investment channel we find robust sizeable effects of VAT changes on consumption even under a limited VAT pass-through. For the specific situation in Germany, we analyze the impact of the VAT reduction in conjunction with the lockdowns in 2020 Q2 to Q4. We use non-linear solution techniques to solve the model in the presence of a ZLB, forced savings and a lockdown constraint. We find a VAT short-term multiplier of one, which reduces over the medium term. Thus, the temporary VAT reduction is an effective instrument in the short-term but not efficient with regard to medium-term budget sustainability. Furthermore, we can show that the VAT reduction is able to mimic the macroeconomic effects of a central bank reaction according to a Taylor rule in case of a lockdown shock. However, compared to the monetary policy reaction the VAT reduction has only small direct effects on private investments.