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Rational Illiquidity and Excess Sensitivity: Theory and Evidence from Income Tax Withholding and Refunds

Author

Listed:
  • Michael Gelman

    (Claremont McKenna College)

  • Dan Silverman

    (Arizona State University)

  • Matthew Shapiro

    (University of Michigan)

  • Shachar Kariv

    (University of California, Berkeley)

Abstract

Nearly a third of all personal income tax collected by the US, government is later returned in the form of tax refunds; and households tend to spend disproportionately from those refunds. This paper develops a theory of liquid assets management that explains why households voluntarily reduce liquidity by overwitholding, but then spend in response to the liquidity provided by tax refunds. Liquidity constraints that arise endogenously when income is uncertain and when adjusting tax payments is not frictionless explain these behaviors. Tax refunds tend to arrive in circumstances where income is lower than expected, so liquidity is low and the MPC is endogenously high. The average amount of income not subject to withholding and the average annual fluctuations in that income are more than sufficient to explain the size of tax refunds, and microevidence supports central mechanisms of the model.

Suggested Citation

  • Michael Gelman & Dan Silverman & Matthew Shapiro & Shachar Kariv, 2019. "Rational Illiquidity and Excess Sensitivity: Theory and Evidence from Income Tax Withholding and Refunds," 2019 Meeting Papers 542, Society for Economic Dynamics.
    • Handle: RePEc:red:sed019:542
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    References listed on IDEAS

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    Cited by:

    1. Gelman, Michael, 2021. "What drives heterogeneity in the marginal propensity to consume? Temporary shocks vs persistent characteristics," Journal of Monetary Economics, Elsevier, vol. 117(C), pages 521-542.
    2. Brian Baugh & Itzhak Ben-David & Hoonsuk Park & Jonathan A. Parker, 2021. "Asymmetric Consumption Smoothing," American Economic Review, American Economic Association, vol. 111(1), pages 192-230, January.
    3. Sydnee Caldwell & Scott Nelson & Daniel Waldinger, 2023. "Tax Refund Uncertainty: Evidence and Welfare Implications," American Economic Journal: Applied Economics, American Economic Association, vol. 15(2), pages 352-376, April.

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