Measuring Intertemporal Substitution in Consumption: Evidence from a VAT Increase in Japan

We estimate the intertemporal elasticity of substitution in consumption (IES) using a preannounced increase in Japan’s consumption tax rate. Because this tax is highly comprehensive, the rate increase was announced prior to its implementation, and because other factors that affect the real interest rate were constant, the tax rate increase presents an ideal natural experiment to estimate the IES. A Japanese monthly household survey is exploited to accurately categorize nondurables, and our empirical specification addresses intratemporal substitution bias. We find that the IES is 0.21 and not significantly different from 0, but it is significantly less than 1.