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Can Tax Rebates Stimulate Consumption Spending in a Life-Cycle Model? (Working Paper 2011-02)

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  • Jonathan Huntley
  • Valentina Michelangeli

Abstract

This paper presents a life-cycle model with earnings risk, liquidity constraints, and portfolio choice over tax-deferred and taxable assets to evaluate changes to household consumption in response to transitory, anticipated income shocks, such as the 2001 federal income tax rebate. Households optimally hold a large share of savings in tax-deferred assets, which are encumbered by withdrawal penalties, and choose to relinquish some taxable precautionary savings in exchange for higher after-tax returns. The model predicts an increase of several percentage points in the marginal propensity to consume out of the tax rebate compared with results from a standard frictionless life-cycle model. Moreover, the model’s liquidity-constrained households—which include households with very few financial assets and those whose portfolios are expensive to reallocate because they contain sizeable tax-deferred investments—consume a higher fraction of the tax rebate than do other types of households. The results presented are in keeping with empirical findings published in the literature concerning the 2001 federal tax rebate.

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Bibliographic Info

Paper provided by Congressional Budget Office in its series Working Papers with number 41581.

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Date of creation: 14 Jul 2011
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Handle: RePEc:cbo:wpaper:41581

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  1. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
  2. Sumit Agarwal & Chunlin Liu & Nicholas Souleles, 2007. "The reaction of consumer spending and debt to tax rebates; evidence from consumer credit data," Working Papers 07-34, Federal Reserve Bank of Philadelphia.
  3. Daniel Bergstresser & James Poterba, 2002. "Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances," NBER Working Papers 9268, National Bureau of Economic Research, Inc.
  4. Melvin Stephens Jr., 2002. "'3rd of tha Month': Do Social Security Recipients Smooth Consumption Between Checks?," NBER Working Papers 9135, National Bureau of Economic Research, Inc.
  5. Jonathan A. Parker, 1999. "The Reaction of Household Consumption to Predictable Changes in Social Security Taxes," American Economic Review, American Economic Association, vol. 89(4), pages 959-973, September.
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  8. Lusardi, Annamaria, 1996. "Permanent Income, Current Income, and Consumption: Evidence from Two Panel Data Sets," Journal of Business & Economic Statistics, American Statistical Association, vol. 14(1), pages 81-90, January.
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  10. Geng Li & Paul A. Smith, 2008. "Borrowing from yourself: 401(k) loans and household balance sheets," Finance and Economics Discussion Series 2008-42, Board of Governors of the Federal Reserve System (U.S.).
  11. Shoven, John B. & Sialm, Clemens, 2004. "Asset location in tax-deferred and conventional savings accounts," Journal of Public Economics, Elsevier, vol. 88(1-2), pages 23-38, January.
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  14. Nicholas S. Souleles, 1999. "The Response of Household Consumption to Income Tax Refunds," American Economic Review, American Economic Association, vol. 89(4), pages 947-958, September.
  15. Joao F. Cocco, 2005. "Consumption and Portfolio Choice over the Life Cycle," Review of Financial Studies, Society for Financial Studies, vol. 18(2), pages 491-533.
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