How does consumption respond to a change in income?:
The consumption response to income changes, by Tullio Jappelli and Luigi Pistaferri, Vox EU: With the recovery underway, the consumption-income link is back in the spotlight. While there is a long tradition of studying the connection, many questions lack definitive answers:
- How does household consumption respond to changes in economic resources?
- Does the response depend on the nature and duration of the changes?
- Do anticipated income changes have a different consumption impact than unanticipated shocks?
- Do transitory income shocks have a lower impact than permanent ones?
- What about small changes compared with large ones?
These questions are crucial for understanding consumers’ behavior and to evaluate fiscal policy changes that impacts households’ resources. Indeed, in virtually all countries, consumption represents more than two thirds of GDP, and knowledge of how consumers respond to income shocks is crucial for evaluating the macroeconomic impact of fiscal packages implemented in response to the financial crisis.
Economists have taken different empirical approaches to estimate these important policy parameters. To put matters in perspective, Figure 1 provides a roadmap to the main links between consumption and income changes. The main distinction that we draw is between the effect of anticipated and unanticipated income changes. The Modigliani and Brumberg (1954) and Friedman (1957) celebrated life-cycle and permanent income models posit that people use savings to smooth income fluctuations, and that they should respond little – if at all – to changes in income that are predictable.
Figure 1. A roadmap of the response of consumption to income changes
More recently, the literature has sought to gain further insights by distinguishing between situations in which consumers expect an income decline or an income increase. A further distinction that has proven to be useful is between large and small expected income changes, as consumers might may react mostly to the former and neglect the impact of the latter. The branch on the right-hand side of the figure focuses instead on the impact of unanticipated income shocks. The main distinction here is between transitory shocks, which should have a small impact on consumption, and permanent shocks, which should lead to major revisions in consumption. As with anticipated changes, the literature has sought to pin down the empirical estimates identifying positive and negative shocks.
Predictable income changes
A first group of researchers has tried to identify specific episodes in which predicted income changes are observable by both the consumer and the econometrician. Such episodes can also be classified into expected income increases and expected income declines.
For instance, Shapiro and Slemrod (2009) use survey data to measure individual responses to actual or hypothetical tax policies, reporting that temporary tax changes could be moderately effective in increasing household spending. Parker (1999) considers the effect on consumption of the anticipated income increase induced by reaching the US social security payroll cap ($106,800 in 2009), and Souleles (2002) how consumption responded to the widely pre-announced tax cuts of the Reagan administration era.
Further insights from tax refunds is provided by Johnson et al. (2006), who study the large income tax rebate program provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. The authors find that the average household spent 20% to 40% of their 2001 tax rebate on non-durable goods during the three-month period in which the rebate was received. The authors also find that the expenditure responses are largest for households with relatively low liquid wealth and low income, which is consistent with the presence of liquidity constraints.
Expected income declines
A second group of authors considers the effect of expected income declines on consumption. The most important predictable decline in one’s income occurs at retirement. One of the first papers to look at this issue is Banks et al. (1998) who found a remarkable drop in consumption after retirement, a finding that has been challenged by subsequent research (Hurd and Rohwedder 2006, and Aguiar and Hurst 2007).
Unanticipated income shocks
The approach taken by economists studying the impact of unanticipated income shocks is to compare households that are exposed to shocks with households that are not (or the same households before and after the shock), and to assume that the difference in consumption arises from the realization of the shocks. The literature has looked at the economic consequences of illness, disability, unemployment, and, in the context of developing countries, weather shocks and crop losses. Some of these shocks are transitory (such as temporary job loss), and others are permanent (disability); some are positive (dividends pay-outs), others negative (illness).
A further approach to identify the consumption response to unanticipated income shocks makes specific statistical assumptions about the income process, and estimates the response of consumption to income shocks. Blundell et al. (2008) find that in the US consumption is nearly insensitive to transitory shocks, while the response of consumption to permanent shocks is about 0.65 (but lower for the college educated and those near retirement and higher for poor or less educated households). Jappelli and Pistaferri (2008) find a response to permanent shocks of about 1 in Italy.
Overall, there is by now considerable evidence that consumption appears to respond to anticipated income increases, over and above by what is implied by standard models of consumption smoothing. In Jappelli and Pistaferri (2010) we cite evidence from diverse sources, studies and countries. We find that, at least locally, financial markets’ arrangements and liquidity constraints are an important culprit for this lack of consumption smoothing. Indeed, consumption appears much less responsive to anticipated income declines (for instance, after retirement), a case in which liquidity constraints have no bearing.
A second finding that emerges from the literature is that the consumption reaction to permanent shocks is much higher than that to transitory shocks. There is also evidence, at least in the US, that consumers do not revise their consumption fully in response to permanent shocks.
Taken together, these findings suggest that tax changes might have a considerable impact on consumption expenditures. However, the precise effect will depend on whether the policy is anticipated, whether taxes increase or decline, whether the change is perceived as temporary or permanent. The main challenge for empirical work evaluating fiscal packages is therefore to distinguish between different expectations and contexts in which tax programs and fiscal packages are implemented.
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Banks, James, Richard Blundell, Sarah Tanner (1998), “Is There a Retirement Savings-Puzzle?”, American Economic Review, 88:769-88.
Blundell, Richard, Luigi Pistaferri, Ian P Preston (2008), “Consumption inequality and partial insurance”, American Economic Review, 98:1887-1921.
Friedman, Milton (1957), A Theory of the Consumption Function, Princeton: Princeton University Press.
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Hurd Michael D, Rohwedder Susann (2006), “Some answers to the Retirement Consumption Puzzle”, NBER Working Paper 242.
Jappelli Tullio, Luigi Pistaferri (2008), “Financial Integration and Consumption Smoothing”, CSEF Working Paper 200.
Jappelli Tullio, Luigi Pistaferri (2010), “The Response of Consumption to Income Changes”, Annual Review of Economics, forthcoming.
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Modigliani Franco, Ricahrd Brumberg (1954), “Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data”, in Kenneth Kurihara (eds), Post-Keynesians Economics, New Brunswick: Rutgers University Press.
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