Do Prices Respond Differently to Increases and Decreases in Consumption Taxes?

This paper shows that prices respond asymmetrically to increases and decreases in consumption taxes. We combine monthly commodity price data with information on Value Added Tax (VAT) rates across several European countries for the period 1996-2015 and show that prices respond more to VAT increases than to decreases. We explain this asymmetric pass-through to prices with a simple model of fairness based on the findings of Kahneman et al. (1986). Our finding cautions against using incidence estimates derived in previous studies without accounting for the direction of the tax change and questions the effectiveness of reductions in consumption taxes to achieve redistribution or stimulate economic growth