DP17953 Consumption Tax Cuts in a Recession
In this paper, I use an estimated structural life-cycle model featuring multiple consumption categories to assess the effectiveness of temporary cuts to the Value Added Tax (VAT) rates on non-durable luxuries and durables as fiscal stimulus instruments during recessions. I find a tax elasticity smaller than 0.5 for non-durable luxuries and a tax elasticity of around 10 for durables. I show that the tax cut on non-durables has an intratemporal substitution effect on non-durables, while the tax cut on durables acts through an intertemporal substitution mechanism in the purchase of durables that is stronger for high income, liquidity unconstrained, and younger households. This mechanism is amplified in less persistent recessions and dampened in the absence of a recession due to the interaction of durables’ partial irreversibility with precautionary saving motives.