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a blog from young economists at Nova SBE

The effect of tax changes on Consumer Spending – The 2008 Economic Stimulus

Many supporters of the tax cut noticed that it as an important stimulus to consumer spending but an analysis of the effect of earlier income tax cuts proposes that the consumer response to such initiatives is quite variable.

According with economic theory, the spending effect is larger when the tax change is legislated to have a permanent effect on tax liabilities but contrary to theory, families adjusted their spending only after tax changes took effect. Thus, forward-looking consumers will change their spending behavior before an income changes.

Most economists believe that consumer spending decisions follow the life cycle and permanent income theories. This theory states that consumers wish to maintain a growth path of spending over their lifetimes. Hence, consumers will be reluctant to changes on spending in response to a variation in income unless they consider that the income change will persist, that is, spending responds to change in “permanent” income. We can call permanent income as expected income.

Applying this theory to tax changes, we understand that consumers will be more likely to alter their spending behavior if they perceive a tax change to be lasting. Therefore, changes in tax rates that are assumed as permanently should have larger effect on consumer spending than a temporary rate variation in exemptions.

An example of tax changes is the 2008 Tax Rebates on Consumer Spending. In response to slowing economic growth, the Federal government of U.S decreed an economic stimulus package consisting mainly of a $100 billion tax rebate program. The policymakers expected that giving money to households they would increase spending levels.

On one hand, some people argued that households wouldn’t spend their tax rebates because consumers are reluctant to swings in their consumption levels, but on the other hand, others argued that since the money to pay for fiscal programs has to be borrowed and paid back in taxes, it’s a wash for the economy as a whole.

Comparing households that received a rebate with those who later receive a rebate, it was possible to conclude that the big spenders were low-income or low-wealth households. Both increased their spending at almost double the rate of the average household. Furthermore, the stores were also affected by the rebate, however, the consumption at supercenters and other non-grocery outlets increased significantly when compared with spending at groceries which declined one percent.

To conclude, the policymakers tried to increase disposable income of households by tax rebates in order to increase or maintain the consumer spending levels and they find positive aspects because the stimulus payments are initially being spent at significant rates.

 Rita Cordeiro #672


Author: studentnovasbe

Master student in Nova Sbe

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