May 7, 2008 — Will the Stimulus Stimulate?

Economists may not expect households to spend their tax rebates, but recent research says otherwise
By Kevin Bryan

Last week, Americans began receiving "economic stimulus" checks from Uncle Sam for up to $1,200, plus $300 for each dependent child. These rebates are expected to be financed by $117 billion in new government debt.

The lawmakers who voted on the package think the money will provide a boost to consumer spending. Speaker of the House Nancy Pelosi echoed other lawmakers by claiming that "the stimulus, the way it is targeted, will put money into the hands of those who will spend it immediately, injecting demand into the economy and therefore creating jobs." Others have raised doubts, saying the tax rebates will have only limited impact on the economy because households will use the money to pay off debt and increase their savings.

So, what economic effects are these rebates likely to have? Recent studies suggest that the money will provide less short-term stimulus than many politicians expect. Yet people won't save as much as economic theory would predict, either.

Traditionally, economists have been wary of the idea that government can take on debt while simultaneously spurring consumers to spend. A theory called "Ricardian Equivalence" — named by economist Robert Barro after the early 19th century economist, David Ricardo — states that consumers see no difference between taxation and government debt. So, when a "Ricardian" consumer receives a rebate check, he will realize that the government has borrowed money to issue the check and that he must pay back the government debt through higher taxes later in life. Because of this, he will save all of the rebate money in order to afford the future taxation.

Over the past few decades, however, economists have found that people don't often act this way. Instead of taking the long view of spending over their lifetime, consumers tend to be excessively sensitive to changes in their current income.

Economists use the phrase "marginal propensity to consume" to describe the degree to which a person's consumption habits change when their income changes. Estimates of the marginal propensity to consume from tax rebates have been constructed by researchers based on the effect of the 2001 rebate, which provided $300 to $600 to taxpayers as a way to blunt the last recession.

Two recent papers by University of Pennsylvania finance professor Nicholas Souleles and his co-authors found that between 20 percent and 40 percent of the 2001 tax rebate was spent on non-durable goods within three months of people receiving their checks. It would seem, at least in part, that people don't act like strictly Ricardian consumers in the real world.

Two factors help explain this. The first is that a consumer who is poor now and expects to be wealthy later may not be able to borrow money on his own to turn that future income into today's spending. But if the government borrows for him by sending him a rebate check, the consumer will be able to buy more now and will not save the money.

"There are a lot of consumers who are credit-constrained or liquidity-constrained, so the rebate gives a real boost to current income," notes Yash Mehra, a senior economist at the Federal Reserve Bank of Richmond. Souleles and his co-authors did indeed find that households with low income or low liquid wealth spent more of their rebate than others.

But the second factor is much more basic: Many individuals simply do not recognize that rebate checks are paid for with government debt which must eventually be repaid by taxpayers. "I don't think the guys who spend the checks read much about the government debt," says Mehra.

Kevin Bryan is a senior research associate in the Richmond Fed's Research Department.

Agarwal, Sumit, Chunlin Liu, and Nicholas Souleles. "The Reaction of Consumer Spending and Debt to Tax Rebates: Evidence from Consumer Credit Data." Federal Reserve Bank of Philadelphia Working Paper 07-34, November 2007.

Johnson, David S., Jonathan A. Parker, and Nicholas S. Souleles. "Household Expenditure and the Income Tax Rebates of 2001." American Economic Review 96 (2006): 1589-1610.