Tag Archives: permanent income hypothesis

McArdle, Stimulus, and the Literature

Megan McArdle writes:

The real question, I think, is how close the permanent income hypothesis is to being true.

Well, there is some recent literature by John Seater (and co-authors) that suggests it is true (see here, here, and here).

She continues:

The basic idea is that people are forward looking, and they try to smooth their consumption over time. So if you give them a “temporary tax cut”, they save most of it, knowing that eventually they will have to give the money back.

But of course, this should also be true of “temporary government spending”–if people think the money won’t be there next year, they’ll salt as much of the money away as possible. This is a topic very underexplored in the various estimates of the stimulus multiplier, even though consumers are massively overleveraged and will presumably save as much of their new income as they can.

She is correct regarding the temporary tax cut, however, her claim regarding government spending is simply incorrect. Under the permanent income hypothesis, individuals base their consumption decisions on the their permanent lifetime income. A permanent increase in government spending is equivalent to an increase in the present value of taxes paid by the household. However, the present value of a temporary increase in government spending is zero (0). The difference between the two is that in the first instance individuals will reduce consumption due to the increase of the present value of taxation, whereas under the latter scenario there is no such expectation.

I am also not sure that this is “underexplored”. Anyone care to defend that claim?