Revisiting the effect of VAT changes on output

Abstract

Standard models used in academic and institutional research implement the value-added tax (VAT) as a simple consumption tax levied on consumers, implying that tax changes instantaneously translate into consumer price changes. This corresponds to immediate tax pass-though, which is, however, inconsistent with a wealth of empirical evidence for gradual pass-through. I investigate how empirically plausible pass-through dynamics affect VAT multipliers in a New-Keynesian DSGE model relative to instantaneous pass-through under the conventional modeling strategy. To this end, I propose an approach to reconcile passthrough in the model with empirical estimates, and find that short-run multipliers decline by about 50% once we account for empirically observed pass-through dynamics. Standard models thus dramatically overestimate the short-run impact of VAT changes.