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The Intertemporal Substitution and Income Effects of a VAT Rate Increase: Evidence from Japan

David Cashin and Takashi Unayama ()

Discussion papers from Research Institute of Economy, Trade and Industry (RIETI)

Abstract: One of the biggest political issues in Japan is an increase in the rate of value added tax (VAT). In this paper, we evaluate its impact on household expenditure, using Japan's April 1997 VAT rate increase from three to five percent as a case study. A rate increase induces price hikes, and provided this increase in price levels is anticipated, households should engage in intertemporal substitution of purchases. In addition, if households are not compensated for the rate increase, it has the potential to induce an income effect on household consumption. Based on monthly household expenditure data, we find that households spent 30,231 yen more in the quarter prior to the rate increase than they would have in its absence, while the income effect was negligible. Consistent with theoretical predictions, increased outlays on durable and storable non-durable goods and services were responsible for roughly three-quarters of the observed intertemporal substitution effects. Contrary to conventional wisdom, we find that the VAT rate increase had no impact on real household spending following its implementation, once we have accounted for intertemporal substitution, which caused a large transitory disturbance in household expenditures.

Pages: 44 pages
Date: 2011-04
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