Fiscal policy and consumption

Tullio Jappelli, Luigi Pistaferri 23 March 2013

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Governments on both sides of the Atlantic have enacted large fiscal stimulus packages to counteract the Great Recession. The effectiveness of these interventions crucially depends on:

  • How consumers respond to fiscal policies;
  • How governments finance stimulus packages.

The key question for policymakers is whether debt-financed fiscal packages are more or less effective than redistributive programmes that maintain the public deficit unchanged.

For instance, fiscal reforms that increase the tax burden of the rich are often advocated as a way to finance the extension of unemployment insurance schemes or other welfare programmes during high-unemployment periods. On the other hand, there is strong political opposition to raising taxes during recessions.

In standard macroeconomic models, revenue-neutral redistributive policies produce no consumption effects in the aggregate because of homogeneity in the marginal propensity to consume. In these models, the consumption of the rich is no more than a scaled-up version of the consumption of the poor, and any increase in the latter’s consumption is matched exactly by a decline in the consumption of the former.

However, more realistic models with precautionary savings or liquidity constraints feature heterogeneity in marginal propensities to consume. These suggest that consumers respond differently to changes in their economic resources. For example:

  • The marginal propensity of prudent individuals falls with household resources; and
  • Liquidity-constrained consumers exhibit higher marginal propensities than households who can access credit markets to smooth consumption.

In addition to these level effects, the composition of household resources may also matter.

Households burdened with a large amount of debt might react to a positive change in income by reducing their debt rather than spending. Moreover, if most of the wealth is locked into illiquid assets, households must cut consumption even in the face of a negative transitory-income shock. Since aggregate consumption depends on the distribution of marginal propensities to consume within the population, redistributive fiscal policy might potentially boost national income.

What all this means is that knowing marginal propensities is a key first step to the design of optimal fiscal-stimulus packages.

Estimating marginal propensities to consume

A major problem in estimating marginal propensities is identifying shocks that affect consumption via changes in income, rather than directly – say through shifts in preferences or wealth. This is necessary since otherwise we cannot be sure we have isolated the impact of income on consumption per se. In other words, we have to isolate the exogenous shocks to income which can be used to track consumption behaviour after a shock.

In recent research we show how this can be overcome by using recent survey data alongside information on how much consumers would spend due to an unexpected windfall gain (Jappelli and Pistaferri 2013). The 2010 Italian Survey of Household Income and Wealth is designed to elicit information on how much people would consume or save were they unexpectedly to receive a reimbursement equal to their average monthly income. The survey question we use is the following: “Imagine you unexpectedly receive a reimbursement equal to the amount your household earns in a month. How much of it would you save and how much would you spend? Please give the percentage you would save and the percentage you would spend”. The responses to this question provide a distribution of the marginal propensity to consume that we can relate to observable characteristics and, most importantly, compare with the predictions of intertemporal consumption models.

In our sample, we find that the average marginal propensity to consume is 48%, at the high end of current estimates based on survey data. But most importantly, as shown in Figure 1, we find substantial heterogeneity in people’s responses. The marginal propensity to consume declines sharply with cash-on-hand, from around 65% in the lowest cash-on-hand percentiles to some 30% for the richest households. Hence, households with low cash-on-hand (or low income and wealth) exhibit a much higher marginal propensity to consume than affluent households.

Figure 1. Average marginal propensity to consume by cash-on-hand percentiles

The empirical distribution of the marginal propensity to consume can be used to perform some simple policy simulations designed to predict the consumption response to tax interventions. We consider the cases of both government enacting a transfer policy financed by issuing debt and government redistributing income from rich to poor in a revenue-neutral scheme. We find that the response of aggregate consumption to these policies is substantially higher than in a benchmark case when the marginal propensity to consume is assumed to be the same for each household. 

We consider several experiments. In the first experiment, we assume that the government enacts a transfer policy financed by issuing debt (no taxes are levied). In particular, we study a policy in which government transfers 1% of national disposable income equally among all individuals in the bottom 10% of the income distribution. This policy is equivalent to a transfer of €3,308 (120% of average monthly income).

We next consider two scenarios: in one, marginal propensity to consume is 0.48 for all individuals (the sample average), and in the other, the marginal propensity to consume is heterogeneous (and equal to the individual marginal propensity to consume as elicited in the survey). In the homogeneous case, the aggregate marginal propensity to consume is obviously equal to 0.48, and aggregate consumption increases by 0.62%. If the marginal propensity to consume is heterogeneous, targeting transfers at the bottom 10% of the population results in a higher aggregate marginal propensity to consume (0.62) and higher aggregate consumption growth (0.82%). The difference between the two cases is explained by the higher marginal propensity to consume prevailing in the bottom part of the cash-on-hand distribution.

Another experiment we consider is to transfer 1% of national disposable income equally among all households with at least one unemployed member (14% of the sample). This is equivalent to an unemployment bonus of €2,400 (about 87% of average monthly income), roughly equal to three months of the unemployment insurance received by blue-collar workers. The quantitative impact of this policy is to boost aggregate consumption by 0.76%, with an estimated aggregate marginal propensity to consume of 0.58. The reason why this policy has effects similar to those of a transfer to the bottom 10% of the income distribution is that households with unemployed members are mostly concentrated among the poor.

A different type of experiment is a balanced-budget redistributive policy whereby the government finances a transfer to the poor by taxing the top 10% of the income distribution. With a homogeneous marginal propensity to consume, a pure redistributive policy has no effect on aggregate consumption. However, with a heterogeneous marginal propensity to consume, the effect is positive and highest if the programme targets the very poor. For instance, a transfer to the bottom 10% of the income distribution would raise aggregate consumption by 0.08%; if the same programme targets people with below-median income, the boost in consumption would be around 0.05%.

One important caveat is that our calculations of the aggregate effects of fiscal policy are performed assuming that fiscal policy does not affect asset prices and that tax changes have no effect on labour supply. Hence, our calculations are likely to be an upper bound to the true effects of fiscal policy.

References

Agarwal, Sumit, Chunlin Liu, and Nicholas S Souleles (2007), “The Reaction of Consumer Spending and Debt to Tax Rebates-Evidence from Consumer Credit Data”, Journal of Political Economy, 115, 986-1019.

Dynan, Karen, Jonathan Skinner, and Stephen P Zeldes (2004), “Do the Rich Save More?”, Journal of Political Economy, 112, 397-444.

Johnson, David S, Jonathan A Parker, and Nicholas S Souleles (2006), “Household Expenditure and the Income Tax Rebates of 2001”, The American Economic Review 96, 1589-1610.

Jappelli, Tullio, and Luigi Pistaferri (2013), “Fiscal Policy and MPC Heterogeneity”, CEPR Discussion Paper No. 9333

Parker, Jonathan A (1999), “The Reaction of Household Consumption to Predictable Changes in Social Security Taxes”, The American Economic Review, 89, 959-7

Parker, Jonathan A, Nicholas S Souleles, David S Johnson and Robert McClelland (2011), “Consumer Spending and the Economic Stimulus Payments of 2008”, NBER Working Papers No. 16684.

Sahm, CR, Shapiro Matthew D, Slemrod Joel (2009), “Household Response to the 2008 Tax Rebate: Survey Evidence and Aggregate Implications”, NBER Working Paper No. 15421.

Shapiro Matthew D, Slemrod Joel (1995), “Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding”, The American Economic Review 85, 274-283.

Shapiro Matthew D, Slemrod Joel (2003), “Did the 2001 Tax Rebate Stimulate Spending? Evidence from Taxpayer Surveys”, in James M. Poterba (ed.) Tax Policy and the Economy 17, Cambridge, MA, MIT Press.

Souleles Nicholas S (1999), “The Response of Household Consumption to Income Tax Refunds”, The American Economic Review 89, 947-958.

Souleles Nicholas S (2002), “Consumer Response to the Reagan Tax Cuts”, Journal of Public Economics 85, 99-120.

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Topics:  Global crisis Macroeconomic policy

Tags:  fiscal policy, consumption

Professor of Economics at the University of Naples Federico II, Director of the Center for Studies in Economics and Finance (CSEF) and a Research Fellow of the Centre for Economic Policy Research (CEPR)

Associate Professor of Economics at Stanford University