The Response of Household Consumption to Income Tax Refunds

Abstract

A central implication of the life-cycle (or permanent-income) theory is that consumption should not respond to predictable fluctuations in income. Tests of this implication have yielded mixed results, especially on micro data (Angus Deaton, 1992; Martin Browning and Annamaria Lusardi, 1996). In large part this might be due to the difficulties of isolating the predictable component of income at the micro level. Most tests proceed by instrumenting for income, but since the available instruments are typically poor, such tests might be prejudiced against finding significant excess sensitivity of consumption to income (John Shea, 1995).' Also, it is not clear how closely the resulting econometric predictions of income coincide with agents' actual expectations of income. To avoid these difficulties this paper examines the response of household consumption to a particular type of income that is both predictable and transitory-income tax refunds. Since a refund depends on events in the previous calendar year, it is predictable income as regards consumption in the year of its receipt. Consequently, under the life-cycle theory consumption should not increase on receipt of a refund.2 In addition to testing the canonical model of consumption, this paper provides estimates interpretable as the marginal propensity to consume (MPC) out of refunds. Since federal tax refunds now amount to over $80 billion per year (averaging well over $1,000 per refund), these estimates are of interest in themselves. More generally they bear on the impact of even preannounced and temporary changes in fiscal policy. The paper begins by surveying related studies in Section I. Section II describes the data, the Consumer Expenditure Survey (CEX), which of the leading U.S. micro data sets has the most comprehensive coverage of expenditure. The empirical specification is set out in Section HI. Section IV reports the results, and Section V concludes.