New study shows: COVID VAT cut significantly boosted private consumption

The study “A Temporary VAT Cut as Unconventional Fiscal Policy” was authored by Rüdiger Bachmann (University of Michigan), Benjamin Born (University of Bonn), Olga Goldfayn-Frank (Deutsche Bundesbank), Georgi Kocharkov (Deutsche Bundesbank, European Central Bank), Ralph Luetticke (University of Tübingen), and Michael Weber (ESMT Berlin, Purdue University). The findings are based on household surveys and data on actual retail purchases during the six-month period in 2020 when the value-added tax was temporarily reduced from 19 to 16 percent. In addition, the researchers simulated the reaction of different household types in a macroeconomic model. 

The basic idea: if VAT falls today and is set to rise again in the foreseeable future, consumption becomes relatively cheaper now than it will be later. This creates an incentive similar to a cut in the key interest rate: people buy sooner rather than later. Unlike interest-rate policy, though, a VAT change is easy for consumers to understand and has an immediate, noticeable effect.  

The study shows that households who perceived a strong pass-through of the tax cut to consumer prices spent around 37 percent more on durable goods, such as cars, in the second half of 2020 than households who perceived little or no effect on prices. For medium-durability goods, such as books, the effect was around 10 percent; for short-lived everyday goods, such as food, no significant effect was found. Shortly after the measure took effect, a survey conducted in July 2020 found that households who knew the tax cut was only temporary were considerably more likely to plan major purchases than households who did. The difference was about ten percentage points.  

In the researchers’ model, the measure drove up total consumption spending by 4.4 percent immediately after its introduction. This is a significantly greater effect than a temporary interest rate cut of the same magnitude would have had. The reason: a tax cut directly increases households’ disposable income, whereas an interest-rate cut does not to the same degree. The strongest response came from younger and middle-aged households with lower net wealth, as well as particularly price-conscious “bargain hunters.” Financial literacy or a long planning horizon, by contrast, played hardly any role. 

„Such a measure essentially works like monetary policy. I make consumption cheaper today than it will be in a year, for instance through a temporary VAT cut that is predictably set to expire again,” says Michael Weber, Alexander von Humboldt professor at ESMT. “The fact that it is precisely lower-income households who respond most strongly is surprising at first, since they often lack the financial leeway for larger purchases. But that is exactly what makes the measure effective, as the price incentive, also reaches households that conventional stimulus programs otherwise struggle to address.” 

At the same time, the study’s authors point out that their findings say nothing about the fundamental merits of the 2020 VAT cut specifically. Their calculations do show, however, that a temporary VAT cut can be a particularly effective tool when the central bank’s interest-rate policy is reaching its limits, for example, when the key rate is close to zero.