The Economics of a Reduction in VAT*

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 has 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 17½ per cent to 15 per cent 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 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.     

Assessing the Temporary VAT Cut Policy in the UK*

This paper concerns the likely impact of a temporary VAT cut stimulus policy on consumer demand in the UK. It suggests that around 75 per cent of the VAT reduction will be passed on to consumers and that consumers will react by maintaining their expenditure levels and therefore increasing their demand for consumption goods. The uncertainty caused by the downturn makes this a more muted impact than we might have hoped, especially on the demand for durable goods. Nevertheless, it is a substantive impact. In general, the uncertainty caused by the recession will tend to reduce the impact of any stimulus package. It is also argued that synchronising the subsequent rise with the economic upturn is critical.     

Durable Goods,Investment Shocks,and the Comovement Problem

Sticky‐price models suggest that capital investment shocks are an important driver of business cycle fluctuations. Despite quantitative importance in explaining business cycles, a comovement problem emerges because the shocks generate intertemporal substitution effects away from consumption toward investment. This paper resolves the problem by extending the standard sticky‐price model to a two‐sector model with consumer durable services. When durable goods are used as investment in capital and consumer durables, positive capital investment shocks also generate intratemporal substitution effects away from consumer durable services toward nondurable consumption that dominates intertemporal effects. Consequently, consumption increases, and the comovement problem is resolved.     

Inflation Taxation and Welfare with Externalities and Leisure

This paper examines how inflation taxation affects resource allocation and welfare in a neoclassical growth model with leisure, a production externality and money in the utility function. Switching from consumption taxation to inflation taxation to finance government spending reduces real money balances relative to income, but increases consumption, labor, capital, and output. The net welfare effect of this switch depends crucially on the strength of the externality and on the elasticity of intertemporal substitution. While it is always negative without the externality, it is likely to be positive with a strong externality and elastic intertemporal substitution.     

The Distributional Implications of Income Under‐Reporting in Hungary*

The ability and inclination of specific social groups to evade tax vary widely, and this leads to considerable variation in the actual tax burden on individuals with similar levels of income. Thus, ignoring tax evasion can be seriously misleading in terms of the distributive and fiscal effects of the tax system. This paper estimates the distributional implications of income tax evasion in Hungary, based on a random sample of the administrative tax records of nearly 230,000 individuals. Gross incomes declared in the administrative tax returns are compared with incomes stated in a nationally representative household budget survey. Our estimates show that the average rate of underreporting is 9–13 per cent, though this conceals a big difference between the self‐employed (who hide the greater part of their income) and employees. The estimates are likely to be lower bounds. These rates are used in a tax– benefit microsimulation model to calculate the fiscal and distributional implications of under‐reporting. Tax evasion reduces households' personal income tax payments by about 16–20 per cent. While the poverty rate increases only slightly, income inequality rises significantly, suggesting that high‐income households tend to evade tax proportionately more. Finally, we find that tax evasion largely reduces the progressivity of the tax system.     

Financial literacy and its consequences: Evidence from Russia during the financial crisis

The ability of consumers to make informed financial decisions improves their ability to develop sound personal finance. This paper uses a panel data set from Russia, an economy in which household debt has grown at an astounding rate, to examine the importance of financial literacy and its effects on behavior. The paper studies both the financial and real consequences of financial illiteracy. Even though consumer borrowing increased very rapidly in Russia, only 41% of respondents demonstrate an understanding of interest compounding and only 46% can answer a simple question about inflation. Financial literacy is positively related to participation in financial markets and negatively related to the use of informal sources of borrowing. Moreover, individuals with higher financial literacy are significantly less likely to report experiencing a negative income shock during 2009 and have greater availability of unspent income and higher spending capacity. The relationship between financial literacy and availability of unspent income is higher in 2009, suggesting that financial literacy may better equip individuals to deal with macroeconomic shocks.     

Housing,Illiquidity, and Wealth

This article develops a model of asset allocation relevant for the representative consumer. Consumption is composed of two items: housing, and other goods and services. The representative household's balance sheet consists largely of a house and a mortgage. Its income statement is dominated by labor earnings, constraining cash expenditures. Housing-market behavior thus underlies intertemporal wealth and consumption allocation. With a housing-dominated portfolio and a maximizing plan, a plausible bound on the intertemporal marginal rate of substitution in consumption can be estimated for a typical household. The model takes account of idiosyncratic characteristics of housing returns and finance. Underwriting standards oblige borrowers to secure mortgage debt with a housing asset and with cash flow, usually from labor income. Access to the mortgage market depends on the loan-to-value ratio, or leverage and debt size, and the debt-coverage ratio, or cash solvency. If there are seasonals or predictable patterns in house returns, their magnitude is amplified for the typical liquidity-constrained household. Empirical results for the aggregate U.S. market confirm predictability and serial correlation in house capital gains. There are seasonals in housing returns. While there is no January effect, above-average returns are obtained during the summer months.     

Distributional consequences of labor-demand shocks: the 2008–2009 recession in Germany

The distributional consequences of the recent economic crisis are still broadly unknown. While it is possible to speculate which groups are likely to be hardest-hit, detailed distributional studies are still largely backward-looking due to a lack of real-time microdata. This paper studies the distributional and fiscal implications of output changes in Germany 2008–2009, using data available prior to the economic downturn. We first estimate labor demand on 12 years of detailed, administrative matched employer-employee data. The distributional analysis is then conducted by transposing predicted employment effects of actual output shocks to household-level microdata. A scenario in which labor demand adjustments occur at the intensive margin (hour changes), close to the German experience, shows less severe effects on the income distribution compared to a situation where adjustments take place through massive layoffs. Adjustments at the intensive margin are also preferable from a fiscal point of view. In this context, we discuss the cushioning effect of the tax-benefit system and the conditions under which German-style work-sharing policies can be successful in other countries.     

A Model of the Confidence Channel of Fiscal Policy

This article presents a simple macroeconomic model where government spending affects aggregate demand directly and indirectly, through an expectational channel. Prices are fully flexible and the model is static, so intertemporal issues play no role. There are three important elements in the model: (i) fixed adjustment costs for investment, which create an inaction zone; (ii) noisy idiosyncratic information about the aggregate economy; and (iii) imperfect substitution among private goods and goods provided by the government. An increase in government spending raises demand for private goods and may prevent a coordination failure. The optimal level of government expenditure is high when the desired level of investment is low, which we interpret as a time of low economic activity.     

Risk aversion, intertemporal substitution, and the aggregate investment-uncertainty relationship

We analyze the role of risk aversion and intertemporal substitution in a simple dynamic general equilibrium model of investment and savings. Our main finding is that risk aversion cannot by itself explain a negative relationship between aggregate investment and aggregate uncertainty, as the effect of increased uncertainty on investment also depends on the intertemporal elasticity of substitution. In particular, the relationship between aggregate investment and aggregate uncertainty is positive even if agents are very risk averse, as long as the elasticity of intertemporal substitution is low. A negative investment-uncertainty relationship requires that the relative risk aversion and the elasticity of intertemporal substitution are both relatively high or both relatively low. We also show that the implications of our model are consistent with the available empirical evidence.     

Assessing the Fiscal Costs and Benefits of A8 Migration to the UK*

This paper assesses the fiscal consequences of migration to the UK from the Central and Eastern European countries that joined the European Union in May 2004 (A8 countries). We show that A8 immigrants who arrived after EU enlargement in 2004 and who have at least one year of residence, and are therefore legally eligible to claim benefits, are 59 per cent less likely than natives to receive state benefits or tax credits and 57 per cent less likely to live in social housing. Furthermore, even if A8 immigrants had the same demographic characteristics as natives, they would still be 13 per cent less likely to receive benefits and 29 per cent less likely to live in social housing. We go on to compare the net fiscal contribution of A8 immigrants with that of individuals born in the UK, and find that in each fiscal year since enlargement in 2004, irrespective of the way that the net fiscal contribution is defined, A8 immigrants made a positive contribution to the public finances despite the fact that the UK has been running a budget deficit over the last few years. This is because they have a higher labour force participation rate, pay proportionately more in indirect taxes and make much less use of benefits and public services.     

Increase in VAT would affect households in different income categories roughly equally

Conclusion An increase in VAT in Germany in the near future cannot be precluded. If the reduced rate remains unchanged, the regressive redistribution effects in the income categories considered here are minor. Rather, an increase in VAT would affect the households of differing income categories virtually equally: the DIW came to the same conclusion as long as 20 years ago. A less pronounced additional burden would only result for households above the income ceiling chosen here of around DM 8 400 (west Germany) and DM 5 200 (east Germany). At the same time any increase in VAT as a proportion of overall fiscal receipts reduces the redistributional effect in favour of low-income households that results, in particular, from the progressive incidence of income tax rates.     

Deregulation,tax reform,and the use of consumer credit

This article analyzes the probable effects of recent deregulation of consumer credit markets and tax reform on household credit-use decisions. The results of the analysis suggest that deregulation of rates of charge for consumer credit contracts accounts for a substantial portion of the increase in consumer credit outstanding relative to household income since 1982. The effect would not originate from the extention of credit in newly deregulated markets to households that had not been able to get credit before (widening of credit use). Rather, it would come from the provision of greater amounts of credit to borrowers in general (deepening of credit use). With regard to tax reform, the probability of debt use is significantly higher for those households most likely to itemize deductions for federal income tax purposes. Holding the level of interest rates constant, tax reform that removes the deductibility of consumer interest is not expected to affect the amount of credit used relative to income but is expected to have a significant effect on the type of debt used by such households. They will likely be early adopters of home equity lines of credit. Their shift from consumer to mortage credit is expected to have a long-term negative effect on the credit quality of consumer credit portfolios.This work was partially supported by the Credit Research Center. Purdue University, West Lafayette, IN 47907.     

VAT and agriculture: lessons from Europe

Little has been written about the treatment of agriculture under the value added tax (VAT). This article attempts to fill the void by surveying and evaluating the situation in the Member States of the European Union (EU) and some other countries. Farmers are often exempted from VAT for administrative and political reasons. But this means that the VAT on their inputs cannot be ‘washed out’ through the tax deduction/credit mechanism. It then has to be borne by the farmers themselves or becomes an indeterminate and capricious element in consumer prices. To compensate farmers for the uncompensated VAT on inputs, the EU has devised a flat-rate scheme that permits them to charge a presumptive rate (approximately equal to the effective VAT rate on sector-wide inputs) on their sales to taxable agro-processing firms which, in turn, are permitted to take a deduction for this flat-rate addition from the VAT on their sales. Obviously, the flat-rate scheme is an arbitrary way of trying to achieve equal treatment between exempt and taxable farmers and between exempt farm products and other taxable goods and services. Full taxation, subject to the general threshold, appears to be the preferred choice.     

The Effects of EU Formula Apportionment on Corporate Tax Revenues*

The European Commission proposes to replace the current system of taxing corporate income using separate accounting by a two‐step ‘consolidation and apportionment’ procedure. This paper uses a large set of unconsolidated firm‐level data to assess the likely impact on corporate tax revenues in each member state. Taking pre‐tax profit as given, overall tax revenues would be likely to drop by 2.5 per cent if companies could choose whether to participate. By contrast, if they were forced to participate, total tax revenues would be likely to increase by more than 2 per cent, leaving some European countries ‐ most notably, Spain, Sweden and the UK ‐ better off. We investigate how sensitive these results are to the apportionment factors used.     

A Proposal to Improve the VAT Treatment of Housing in the European Union*

The treatment of housing is one of the most difficult issues under the VATs in the EU. Ideally, rents and rental values should be taxed just like other consumer goods and services, but doing so would present formidable practical and political difficulties. Under a second‐best approach, the value of newly created residential (and other) property is taxed as a proxy for the VAT that should be payable on the flow of housing (building) services. This implies, however, that future increases (and decreases) in the value of the exempt property are left out of the VAT base. To remedy this defect, this paper recommends taxing the increases (refunding the tax related to decreases) realised at the time of sale of the exempt used property. This VAT should replace the current transfer, registration and stamp duties, which are highly distortionary. Beyond that, the VATs in various member states can be improved by limiting the exemption for all used immovable property to housing, by taxing land and by applying the standard rate more widely than is currently the case.     

Price Stability in Economies with Habit Persistence

This paper shows that the divine‐coincidence does not hold in a sticky price model with external habit if a time‐varying tax rate on labor income is not implemented to fully eliminate the time‐varying distortions associated with external habit and monopoly power in goods market. The required labor income tax rate is inversely related to the risk‐free real interest rate and the markup in the goods market, but it is proportional to the degree of external habit. Under this circumstance, the optimal monetary policy commands a countercyclical interest rate, having a perfect negative correlation with tax rate in the sticky price model with external habit. If a time‐invariant tax is the only fiscal instrument, then the degree of external habit entails a gap between the private marginal rate of substitution between consumption and labor and the social marginal rate of substitution, generating an endogenous trade‐off between the stabilization of welfare‐relevant output gap and inflation. Under this circumstance, price stability is not the optimal policy. The monetary policy authority should optimally try to undo the time‐varying distortions associated with external habit and monopoly power in goods market by deviating from price stability.     

Precautionary Saving and Consumption Smoothing across Time and Possibilities

This paper examines how aversion to risk and aversion to intertemporal substitution determine the strength of the precautionary saving motive in a two-period model with Selden/Kreps–Porteus preferences. For small risks, we derive a measure of the strength of the precautionary saving motive that generalizes the concept of "prudence" introduced by Kimball (1990b) . For large risks, we show that decreasing absolute risk aversion guarantees that the precautionary saving motive is stronger than risk aversion, regardless of the elasticity of intertemporal substitution. Holding risk preferences fixed, the extent to which the precautionary saving motive is stronger than risk aversion increases with the elasticity of intertemporal substitution. We derive sufficient conditions for a change in risk preferences alone to increase the strength of the precautionary saving motive and for the strength of the precautionary saving motive to decline with wealth. Within the class of constant elasticity of intertemporal substitution, constant-relative risk aversion utility functions, these conditions are also necessary.     

Food prices,tax reforms and consumer Welfare in Tanzania 1991–2007

This paper analyses the effect of observed food price changes on household consumption (welfare) in Tanzania and from this simulates the welfare effect attributable to tax (tariffs and VAT) reforms. The three rounds of the Tanzania Household Budget Survey (1991/92, 2000/01 and 2007) are used to apply Deaton’s method based on median unit values (prices) and household budget shares. The results indicate that real price increases over 1991–2007 have reduced welfare of the average household by 20 per cent of 1991 income, and the loss was fairly evenly distributed between the 1990s and 2000s. The welfare loss was much greater for the poor, especially the rural poor (a 27 per cent reduction), compared to the non-poor (in particular the urban non-poor, who suffered a five per cent loss). Although we cannot establish explicit links between tax reforms and domestic commodity price changes, to assess the extent to which welfare changes can be explained by tax reforms we simulate the effects of tax changes on domestic price changes. The simulation shows that tax reforms (tariff reductions) offset the welfare losses for all household groups, especially in the 1990s; although the differences were small, the urban poor benefit more in relative terms from tax reforms whereas the rural poor benefit least (the effect on the non-poor was similar irrespective of location).     

Intergenerational Differences in Income and Wealth: Evidence from Britain

How do average levels of income and wealth differ in Britain for those born between the 1930s and 1980s? Those in the 1980s cohort are the first post‐war generation not to have higher median incomes in their early 30s than those born a decade earlier, though they have much higher incomes than those born in the 1960s and earlier. Median wealth for those in the 1980s cohort is 20 per cent lower in their early 30s than it was for those born in the 1970s. This is driven by lower property wealth and homeownership: 40 per cent at age 30 for the 1980s cohort, compared with 55 per cent for the 1970s cohort.