Here is a suggested data response plan for a question on the recently announced German fiscal stimulus.
Using the data provided and with the aid of an aggregate demand and supply diagram, consider the likely macroeconomic effects of a cut in VAT on the German economy (10 marks)
One impact could be to increase consumer demand as a 3% fall in VAT might lead to lower prices. If prices fall, this leads to a rise in real incomes which therefore raises household’s purchasing power. Consumption is the biggest component of AD and likely that the cut would raise consumer confidence, adding to demand. Table 2 shows a forecast fall in consumption of 10% in 2020 but a rebound of 7% in 2021 – perhaps helped by the decision to cut VAT.
The impact of a fall in VAT on consumers depends in part on whether German businesses choose to pass on some or all the tax reduction in lower prices. They might seek to keep prices constant to help restore profits. Table 2 shows a forecast 9.3% fall in capital investment suggesting low profitability. VAT exemption for 6 months (i.e. cutting VAT to zero) might make a bigger difference.
A cut in VAT could stimulate business investment. VAT is charged to suppliers, so a fall in VAT will increase their operating profits and lift business “animal spirits” leading to an increase in demand for capital goods. Investment likely to drop by more than 20% in 2020, suggesting a VAT fall would be welcome. (AD-AS diagram)
Investment is driven by many factors and tends to lag changes in operating profits. A 6-month 3% reduction in VAT is unlikely to be very effective in increasing planned investment. Perhaps a policy with more impact such as the increased subsidies for buyers of electric cars will increase investment in e-vehicles and infrastructure.
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