The Transitory VAT Cut in the UK: A Dynamic General Equilibrium Analysis

This paper studies the macroeconomic effects of the transitory Value Added Tax (VAT) cut in the UK using a dynamic general equilibrium approach. The temporary VAT cut policy was announced on 24 November 2008, and was due to come into effect on 1 December 2008, with VAT reverting to its previous level as from 1 January 2010. We quantify the effects of that temporary fiscal stimulus policy on the key aggregate variables of the UK economy and on tax revenues. Overall, we obtain that this policy is too temporary to have important quantitative effects on the economy but qualitative effects are of great interest. We show that the temporary VAT cut will generate an overshooting effect on key macroeconomic variables, and will provoke a significant reduction in investment. Consumption and output will increase during the VAT cut, but they will decrease below their steady state values after VAT reverts to the previous level. Our model economy also predicts that fiscal revenues will decrease about three per cent during the VAT cut. Finally, we find that the VAT cut policy would have provided better results if it had been announced earlier. ‘There is no such thing as a good tax’ — Winston Churchill