The Impact of a Permanent Income Shock on Consumption: Evidence from Japan's 2014 VAT increase

         
Author Name David CASHIN (Federal Reserve Board of Governors) / UNAYAMA Takashi (Faculty Fellow, RIETI)
Creation Date/NO. March 2016 16-E-052
Research Project Sustainable Growth and Macroeconomic Policy
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Abstract

We test the Life Cycle/Permanent Income Hypothesis (LCPIH) using Japan's 2014 value-added tax (VAT) rate increase as a natural experiment. The VAT rate increase represents an unanticipated and proportional reduction in lifetime resources for several reasons: few goods and services are exempt from the VAT; the tax rate increase was uncompensated; it was fully passed on to households in the form of higher prices; and the VAT increase was not anticipated prior to Prime Minister Shinzo Abe's October 2013 announcement. Contrary to the excess smoothness literature, we find that consumption fell in proportion to the income shock upon announcement, implying that we cannot reject the LCPIH.