Question

Consider a country where everyone behaves according to Friedman’s Permanent Income Hypothesis. Which of the following two policy options is likely to have a bigger effect on this year’s level of consumer spending? Assume that labor supply isn’t affected at all by this policy change and that taxes are lump-sum.

a. A $1 billion, one-time, temporary tax cut that will take place 5 years from now.

b. A $100 million, one-time, temporary tax cut that will take place immediately. In no more than four sentences, explain your answer. In another two sentences, summarize some empirical evidence relating to Friedman’s hypothesis.

Answer 1

According to the permanent income hypothesis, people respond to their permanent long term income. If they anticipate an increase in their long term income, then their current spending will also increase. Given this, the first policy will have a bigger impact on the consumer spending of the currenct year, People will anticipate the higher tax cut in the future peiod, and will start saving up for that. Their current expenditure will reduce in anticipation of the lower future income.

Nicholas Souleles (1999) conducted a study where he examined the effect of a tax refund on the consumption of the poeple. Since a tax refund is a return from the last year's income, it should not increase consumption in the month when it is received. However, it was observed that there is a positive relation between the consumption spending and the month in which the tax refund was received.