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The Intertemporal Substitution and Income Effects of a VAT Rate Increase: Evidence from Japan

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  • David CASHIN
  • UNAYAMA Takashi

Abstract

One of the biggest political issues in Japan is an increase in the rate of value added tax (VAT). In this paper, we evaluate its impact on household expenditure, using Japan's April 1997 VAT rate increase from three to five percent as a case study. A rate increase induces price hikes, and provided this increase in price levels is anticipated, households should engage in intertemporal substitution of purchases. In addition, if households are not compensated for the rate increase, it has the potential to induce an income effect on household consumption. Based on monthly household expenditure data, we find that households spent 30,231 yen more in the quarter prior to the rate increase than they would have in its absence, while the income effect was negligible. Consistent with theoretical predictions, increased outlays on durable and storable non-durable goods and services were responsible for roughly three-quarters of the observed intertemporal substitution effects. Contrary to conventional wisdom, we find that the VAT rate increase had no impact on real household spending following its implementation, once we have accounted for intertemporal substitution, which caused a large transitory disturbance in household expenditures.

Suggested Citation

  • David CASHIN & UNAYAMA Takashi, 2011. "The Intertemporal Substitution and Income Effects of a VAT Rate Increase: Evidence from Japan," Discussion papers 11045, Research Institute of Economy, Trade and Industry (RIETI).
    • Handle: RePEc:eti:dpaper:11045
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    File URL: https://www.rieti.go.jp/jp/publications/dp/11e045.pdf
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    References listed on IDEAS

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    3. Louis Kaplow, 2006. "Capital Levies and Transition to a Consumption Tax," NBER Working Papers 12259, National Bureau of Economic Research, Inc.
    4. Karel Mertens & Morten O. Ravn, 2012. "Empirical Evidence on the Aggregate Effects of Anticipated and Unanticipated US Tax Policy Shocks," American Economic Journal: Economic Policy, American Economic Association, vol. 4(2), pages 145-181, May.
    5. Melvin Stephens & Takashi Unayama, 2011. "The Consumption Response to Seasonal Income: Evidence from Japanese Public Pension Benefits," American Economic Journal: Applied Economics, American Economic Association, vol. 3(4), pages 86-118, October.
    6. Igal Hendel & Aviv Nevo, 2004. "Intertemporal Substitution and Storable Products," Journal of the European Economic Association, MIT Press, vol. 2(2-3), pages 536-547, 04/05.
    7. Masao Ogaki & Carmen M. Reinhart, 1998. "Measuring Intertemporal Substitution: The Role of Durable Goods," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 1078-1098, October.
    8. Robert Summers & Alan Heston, 1991. "The Penn World Table (Mark 5): An Expanded Set of International Comparisons, 1950–1988," The Quarterly Journal of Economics, Oxford University Press, vol. 106(2), pages 327-368.
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    Cited by:

    1. Takeo Hoshi & Takatoshi Ito, 2013. "Is the Sky the Limit? Can Japanese Government Bonds Continue to Defy Gravity?," Asian Economic Policy Review, Japan Center for Economic Research, vol. 8(2), pages 218-247, December.
    2. David CASHIN & UNAYAMA Takashi, 2012. "Short-run Distributional Effects of VAT Rate Change: Evidence from a consumption tax rate increase in Japan," Discussion papers 12029, Research Institute of Economy, Trade and Industry (RIETI).
    3. Thomas Crossley & Hamish Low & Cath Sleeman, 2014. "Using a temporary indirect tax cut as a fiscal stimulus: evidence from the UK," IFS Working Papers W14/16, Institute for Fiscal Studies.

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