Non-technical summary

Research Question

When conventional monetary policy is constrained, theory suggests that changes in consumption taxes can be used to engineer changes in intertemporal price and to manage aggregate demand. Does it work in practice? To study the effectiveness and transmission channels of such fiscal policy, we exploit the unexpected announcement of the German federal government to temporarily cut the value added tax (VAT) rate in July 2020, effective until the end of the year.

Contribution

Identifying the causal effect of this policy is difficult as changes in the VAT rate affect all consumers in an economy. We employ survey methods to tackle this challenge. At the initiation of the tax cut, we ask German individuals about their knowledge of the tax changes. After the tax raise, we ask about the belief of the VAT pass-through. We use the differences in information and beliefs as identification to study the intertemporal effect on spending.

Results

We find that the temporary VAT cut led to a substantial relative increase in durable spending: Households spent about 36% more than they would have absent the change in VAT. This effect was smaller for semi- and non-durable goods. Back of the envelope calculations suggest an aggregate effect of 34 billion Euros in additional overall consumption spending due to the policy measure. While younger and financially less fortunate households increase consumption more strongly, the effect is not concentrated around particularly financially literate households. This is in contrast with unconventional monetary policy, which often relies on consumer sophistication.

The authors conclude that an unexpected temporary VAT cut operates like conventional monetary policy and can be an effective stabilization tool when unconventional monetary policy might be less effective.