income effect

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 as 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.