Thursday, 12 April 2012

Modern consumption theory - temporary vs permanent income

One of the main arguments in favour of a fiscal stimulus include the idea that tax rebates will work towards encouraging consumption, and hence aggregate demand. If the people suddenly gain unanticipated funds which will increase their disposable income, this should encourage them to spend this money immediately. On the supply side the argument is to cut personal income taxes in order to increase the disposable income and then consumption. The real problem is that both of these policies won't do much help to temporary consumption especially if confidence in the economy is low. Even though a tax decrease has a positive effect on disposable income, it will yield the same effect on consumption only if the tax decrease is considered to be credible. 

The distinction between temporary and permanent income is an important parameter in determining the real effects of tax policy. If citizens find themselves suddenly with more cash back than they expected, logic permits that they spend this temporary increased disposable income on durable goods that will initiate a temporary spike in consumption.

Figure 1. Changes in US Real Disposable Personal Income (blue) and
Real Personal Consumption Expenditures (red) 1958 - 2011.
Source: St. Louis Fed, FRED database

However, this might not be true in the real world. According to Figure 1. above, spikes in p/c disposable income didn't result in much rise in consumption. On the graph, several of these are noticeable - 1975, 1987, 1993, 2001 along with some others. For the 2008 tax rebate, Christina Romer claimed it had a big effect in not letting consumption fall any further, while John Taylor claims there was no effect at all and that it all went into savings. 

Taylor's argument could be true, especially if we look at the change in the savings rate during the crisis years.

Figure 2. US Personal Savings Rate 1958 - 2011. Source: St. Louis Fed.
FRED Database 
According to Figure 2, people increased their savings during the crisis years. This is, of course, an expected effect. In uncertain times people chose to put away their money and 'play it safe'. Tax rebates or even tax cuts (unless they are considered credible which takes time) won't initiate consumers to spend more, as they are currently in the process of deleveraging. They will use the money to pay off debt and save more in accordance to an uncertain future.

The reason is the distinction between temporary and permanent income. If people anticipate a rise in tax rebates or any other form of stimuli (this is true for companies as well, not just consumers) to be temporary, they will save this money instead of spend or invest it. But when they anticipate a permanent rise in income (like getting a new or better paid job) they are much more likely to spend or invest now as they anticipate a certain future stream of income. With a temporary cut or rebate, they know that next year this won't happen so they better put the money away for now. 

This is why the policy shift must come from a different angle - restoring confidence and pro-market structural reforms

7 comments:

  1. I don't know about temporary and permanent income, but I am tolerably certain that temporary tax cuts do absolutely nothing. They have no noticeable stimulative effect. If fact they may be worse than nothing since they represent some change and instability.

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  2. the savings rate decrease all these years is good proof of overheating and systemic instability that accumulated over the last 20 years. It describes well Bernanke's global savings glut story. Maybe we really do need to save more money and the crisis was a signal for us to start doing that again. A 2.5% savings rate was too low to keep risk-taking under control. I would even think of linking this to the rise of the financial sector during the last 20 years, as the fall of the savings rate and the financialization of the system tend to collide. I would say that in Britain this was even more obvious since the "Big Bang" in the 80s

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    1. The current increase of the savings rate is a temporary phenomenon and can only be linked to the effects of the crisis. When people are uncertain they save more. As soon as they start feeling confident enough to start spending (or investing) they will do so and the savings rate will go down again.

      I don't agree with you that the market is sending a signal to have higher savings rates in order to curb risk-taking. The development of the economy from the 70s and the 80s was grand - information circulates much faster and is widely available, consumption is moving online, consumer credit became easier to get and so on. In such a dynamic, consumerist economy, it's hard to expect to have the savings rate go back to 10%. People simply have much more to do with their money today.

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  3. It would be interesting to see what was the amount of investments in the same period according to the S = I equation. Maybe mechanism gives in a way that consumer "give" money to the banks (or life insurers) and they invest it "for them".

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    1. If you take a look at this graph you can notice a sort of an inverted relationship between domestic private investments and the savings rate, which is a logical effect - in good times people choose to invest more, while in bad ones, they save up due to uncertain times.

      the effect can again be explain through the prism of temporary vs. permanent income - based on the expectations of the current income, people will chose their current rates of spending, investments and savings.

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    2. *sorry, expectations of future income

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