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The Impact on Consumption and Saving of Current and Future Fiscal Policies

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  • Katherine Grace Carman
  • Jagadeesh Gokhale
  • Laurence J. Kotlikoff

Abstract

This paper uses ESPlannerTM -- a life-cycle, financial planning model -- to investigate the potential impact of alternative fiscal policies on current consumption and saving. Studies to date have examined the response of current consumption to tax-induced temporary and permanent income changes. To our knowledge however, no study has directly examined whether consumption smoothing is actually feasible. ESPlanner's saving and life insurance recommendations generate the smoothest possible survival-state contingent lifetime consumption path for the household without putting it into debt. Such consumption smoothing is predicted by economic theory and appears to accord closely, on average, with actual behavior. By running households through ESPlanner based on current policy as well as on alternative fiscal policies, one can easily compare the program's consumption response to hypothetical tax and transfer policy changes and assess the degree to which borrowing constraints may be playing a role in determining the size of those responses. The households used in our analysis are drawn from the Federal Reserve's 1995 Survey of Consumer Finances. This data set provides detailed information on household earnings, assets, housing, demographics, and retirement plans -- all of which is used by ESPlanner in formulating its recommendations. The policies we consider are tax hikes, tax cuts, social security benefit cuts, and the elimination of tax-deferred saving. Our analysis distinguishes between immediate and future policy changes as well as between permanent and temporary ones. Our results are influenced by the fact that a majority 57 percent of our sample of households, many of which are young, is borrowing-constrained and, thus, more responsive to current than future policy changes no matter how long their duration. The results are also very sensitive to the particular policy being enacted. Income tax changes, for example, have little effect on the consumption/saving of low-income households for the simple reason their income tax liabilities are relatively small. And social security benefit cuts will have minor effects on the young because they lie so far in the future and the young are generally borrowing constrained. On the other hand, eliminating tax-deferred saving will have no effect on current retirees greatly influence the spending of the young, since such a policy would relax their borrowing constraints. The significant heterogeneity in consumption/saving responses to policy changes depending on the ages and resource levels of the households in question and the particular policy undertaken makes it difficult to summarize our quantitative findings apart from saying that each of the policies considered has a quite sizeable impact on the current consumption and saving behavior of a substantial subset of our sample.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10085.

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Date of creation: Nov 2003
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Handle: RePEc:nbr:nberwo:10085

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  1. B. Douglas Bernheim & Katherine Grace Carman & Jagadeesh Gokhale & Laurence J. Kotlikoff, 2003. "Are Life Insurance Holdings Related to Financial Vulnerabilities?," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 41(4), pages 531-554, October.
  2. Robert E. Hall, 1987. "Consumption," NBER Working Papers 2265, National Bureau of Economic Research, Inc.
  3. Jagadeesh Gokhale & Laurence J. Kotlikoff & Mark J. Warshawsky, 2001. "Life-Cycle Saving, Limits on Contributions to DC Pension Plans, and Lifetime Tax Benefits," NBER Working Papers 8170, National Bureau of Economic Research, Inc.
  4. Martin Browning & Annamaria Lusardi, 1996. "Household Saving: Micro Theories and Micro Facts," Discussion Papers, University of Copenhagen. Department of Economics 96-01, University of Copenhagen. Department of Economics.
  5. N. Gregory Mankiw, 2000. "The Savers-Spenders Theory of Fiscal Policy," NBER Working Papers 7571, National Bureau of Economic Research, Inc.
  6. David W. Wilcox, 1987. "Social security benefits, consumption expenditure, and the life cycle hypothesis," Working Paper Series / Economic Activity Section, Board of Governors of the Federal Reserve System (U.S.) 78, Board of Governors of the Federal Reserve System (U.S.).
  7. Jagadeesh Gokhale & Laurence J. Kotlikoff, 2001. "Who gets paid to save?," Working Paper, Federal Reserve Bank of Cleveland 0114, Federal Reserve Bank of Cleveland.
  8. Nicholas S. Souleles, 1999. "The Response of Household Consumption to Income Tax Refunds," American Economic Review, American Economic Association, American Economic Association, vol. 89(4), pages 947-958, September.
  9. Alan S. Blinder, 1978. "Temporary Income Taxes and Consumer Spending," NBER Working Papers 0283, National Bureau of Economic Research, Inc.
  10. Jonathan A. Parker, 1999. "The Reaction of Household Consumption to Predictable Changes in Social Security Taxes," American Economic Review, American Economic Association, American Economic Association, vol. 89(4), pages 959-973, September.
  11. B. Douglas Bernheim & Lorenzo Forni & Jagadeesh Gokhale & Laurence J. Kotlikoff, 2001. "The mismatch between life insurance holdings and financial vulnerabilities: evidence from the Health and Retirement Survey," Working Paper, Federal Reserve Bank of Cleveland 0109, Federal Reserve Bank of Cleveland.
  12. McCarthy, Jonathan, 1995. "Imperfect insurance and differing propensities to consume across households," Journal of Monetary Economics, Elsevier, Elsevier, vol. 36(2), pages 301-327, November.
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Cited by:
  1. Erling Holm√ły & Kyrre Stensnes, 2008. "Will the Norwegian pension reform reach its goals? An integrated micro-macro assessment," Discussion Papers, Research Department of Statistics Norway 557, Research Department of Statistics Norway.

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