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Many supporters of the tax cut enacted this summer viewed it as an important stimulus to consumer spending. But an analysis of the effects of earlier income tax cuts suggests that the consumer response to such initiatives is, in fact, quite variable. Two conclusions stand out: First, consumers will be more likely to boost spending if the change in tax liabilities is permanent. Second, consumers will wait to increase spending until a tax change affects their take-home pay.
The near-term effect of tax cuts on the economy has generated considerable interest among policymakers and economists this year. Much of the discussion has centered on the question whether tax cuts are an effective spur to consumer spending. This question was at the heart of the legislative debate over the Bush Administration's tax package, and it continues to stir controversy as various economic stimulus plans are put forward in the wake of the September 11 terrorist attacks.
In this edition of Current Issues, we cast new light on the debate by reviewing how past tax changes affected consumer spending. Specifically, we look at the impact of major federal income tax changes in 1968, 1975, and 1982 and the effect of changes in Social Security payroll taxes and benefits. Our study begins with a look at what economic theory predicts about consumer responses to tax cuts, and throughout the analysis, we compare actual responses with those implied by theory.
We find that while almost all of the tax and benefit changes examined in the study prompted changes in consumer spending, the magnitude of the responses varied greatly. In conformity with economic theory, the spending effect was larger when the tax change was legislated to have a permanent effect on tax liabilities. Contrary to theory, however, households adjusted their spending only after tax changes took effect. This finding challenges the standard assumption that forward-looking consumers will alter their spending behavior in anticipation of an income change.
Life Cycle-Permanent Income Theory of Spending
Most economists believe that consumer spending decisions follow the broad criteria set out in the life cycle and permanent income theories-two closely related hypotheses that, in the remainder of this article, are treated as a single theory.1 This theory holds that consumers wish to maintain a...