Permanent Income Hypothesis and the 2001 Tax Cuts

July 14, 2005

Policymakers often try to push economies out of recession with tax cuts. But do temporary tax cuts make economic sense?

Many economists argue they don’t. Why? Because the theory of consumer choice suggests temporary tax changes won’t do much to change behavior.

The logic is simple: People base their decisions on their long-term or “normal” income. In doing this, they tend to smooth consumption over their entire lifetime. That means changes in income people see as temporary—including one-time tax rebates—shouldn’t effect behavior much.

After all, compared to total lifetime income tax rebates are tiny. That means we’d expect people to mostly save them, spending just a little now and spreading the rest out over decades.

So is the theory correct? According to at new NBER working paper by David S. Johnson, Jonathan A. Parker and Nicholas S. Souleles that measures changes in consumer spending following the 2001 Bush tax cut, the evidence is surprisingly mixed. It appears a large chunk of the 2001 tax rebates were spent immediately, and not saved as theory would predict. From the authors:

This paper uses unique data and features of the 2001 income tax rebates to estimate the causal effect of these rebates on household expenditure. The Economic Growth and Tax Relief Reconciliation Act of 2001 sent tax rebates, typically $300 or $600 in value, to about two-thirds of U.S. households over a ten-week period from late July to the end of September, 2001…

This paper finds significant evidence that households spent much of their 2001 income tax rebates. Specifically, households spent about 20-40 percent of their rebates on nondurable consumption goods during the three-month period in which the rebates arrived…

What do these results imply in terms of the economic stimulus provided by the rebate checks? In aggregate… the receipt of the tax rebates directly raised [personal consumption] by about 0.8 percent in the third quarter of 2001 and 0.6 percent in the fourth quarter, and raised nondurable [personal consumption] by 2.9 percent and 2.0 percent in the third and fourth quarters. (Read the full paper here).

So what’s wrong with the permanent income hypothesis?

One possibility is that it assumes people have perfect liquidity—that they can smooth out consumption by costlessly borrowing and loaning—which isn’t always true. In reality, low-income and young people have less access to liquidy. So we’d expect lower-income people to violate the theory and spend most of a temporary tax cut up front.

Not surprisingly, that’s exactly what Johnson, Parker and Souleles find—taxpayers with the least access to liquidity were the most likely to spend their rebates. So their results may be consistent with a modified version of the permanent income hypothesis after all.



Related Articles