The rock-bottom interest rates in place since the 2008–09 financial crisis robbed policy makers of a favorite tool for quickly countering economic downturns: the ability to cut the cost of borrowing money. Over the past decade and a half, central bankers and governments have been forced to experiment with assorted unconventional policy alternatives.

One of them was Germany’s reduction of the national value-added tax as part of an economic stimulus package during the COVID-19 pandemic–driven downturn. The government’s surprise move not only helped stabilize the economy but also showed that such a tax reduction can work as a piece of unconventional fiscal policy, research suggests. The VAT reduction drove an additional €34 billion (US$38.5 billion) of consumer spending, according to the study.

“The unexpected, temporary VAT cut in Germany in the second half of 2020 worked as a measure of unconventional fiscal policy,” write the researchers, including Chicago Booth’s Michael Weber. “Higher expected future prices are tantamount to lower current real interest rates, which should incentivize spending today.”

A VAT accumulates at each production stage of a good or service and is the world’s most common form of consumption tax, levied almost everywhere except in the United States. In Germany, it adds up to 19 percent for consumers—although that was cut to 16 percent for six months in 2020.

To gauge the effects of this change, the researchers added questions to a monthly consumer survey initiated by the German central bank in April 2020, commissioned a separate independent survey of about 10,000 German consumers in early 2021, and analyzed retail sales data.

The significantly lower prices from the VAT reduction gave consumers an incentive to spend before taxes went back up at year-end. Granted, only 60 percent of survey respondents understood the short-term incentive involved, while 40 percent did not. This allowed the researchers to compare the responses of the two groups.

They find that consumers aware of the temporary incentive spent 36 percent more on durable goods (think cars and furniture), 11 percent more on semidurable goods (such as clothing and footwear), and 2 percent more on nondurables (including food, beverages, and gasoline) in the second half of 2020.

Bargain hunters and younger households were the most likely to take advantage of the tax savings, the researchers find. “Households of low net wealth appear to be particularly responsive to temporary VAT cuts,” they write. The straightforward nature of the program was easy for many consumers to take advantage of without sophisticated knowledge, which contributed to the policy’s success, the researchers write.

As a policy tool, the VAT cut had advantages over other measures, such as the direct cash payments rolled out by the US government, the study finds. German consumers had to spend money to fully benefit from the lower VAT, so they couldn’t stash it away in savings as many Americans did with pandemic relief funds. In Germany, the opportunity to save money on purchases added an incentive for families to spend the €300 per child in cash transfers that they also received under the stimulus package, the researchers argue, noting that people’s intentions to buy things increased as the expiration of the VAT cut approached.

Still, the researchers allow for the possibility that there could be even better options available. “We do not take a stance on the optimality or even the appropriateness of this policy measure,” the researchers write. “We do show, however, that . . . an unexpected temporary VAT cut operates indeed like conventional monetary policy and can be an effective stabilization tool.”

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