RDP 2009-07: Estimating Marginal Propensities to Consume in Australia Using Micro Data 5. The Response of Expenditure to Tax Cuts

Laura Berger-Thomson, Elaine Chung and Rebecca McKibbin

November 2009

The results from estimating the effect of tax cuts on both non-durable and strictly non-durable expenditure are presented in Table 4. All standard errors are corrected for heteroskedasticity using the White's transformation of the error matrix. In all fixed-effects specifications, a Hausman test confirmed that the fixed-effects estimation was more appropriate than random effects. The estimated MPC of 1.0 for non-durables is broadly consistent with the PIH (the point estimate for Model (I) implies that for every $100 reduction in tax paid consumption is higher by $103).[20] This falls to 0.8 when we restrict expenditure to strictly non–durables.[21] The estimates are also lower when estimated using first-differences as compared with using fixed effects.

Table 4: Expenditure (in $100) – Tax Cut Regressions
Non-durable Strictly non-durable(a)
Fixed effects First differences Fixed effects First differences
I II III IV
Tax ($100) 1.03*** 0.87***   0.78*** 0.68***
Wave 5 dummy −35.70*** −38.74***   −31.47*** −33.68***
Wave 6 dummy −4.56** −5.70***   −3.92** −4.79***
No of children 8.65** 7.17**   8.47*** 7.65**
No of adults 38.55*** 38.78***   30.76*** 31.82***
House value ($10,000) 0.16* 0.12*   0.11 0.08
Credit card 5.63** 4.71   4.13* 3.60
R2-within 0.17 –   0.16 –
R2-between 0.13 –   0.12 –
R2-adjusted – 0.12   – 0.11
Notes: ***, ** and * denote statistical significance at the 1, 5 and 10 per cent levels respectively. There are 13494 observations in the fixed-effect specification and 7429 observations in the first-differences equation (5576 households).
(a) Expenditure excludes education, clothing and footwear, and motor vehicle repairs and maintenance.

The estimated MPCs are slightly larger than estimates in the literature for the United States. In particular, the fixed-effects model suggests that all of the extra income is allocated to non-durable expenditure. A high estimate is consistent with Parker (1999), who finds that reductions in withholding taxes in the United States are disproportionately spent on non-durables. This may reflect the fact that small, persistent increases in disposable income are treated differently to large increases in income, and are more likely to be spent on non-durables. The fact that our estimate is higher than many US studies can be partly explained by the different nature of the income changes examined. Since the tax changes we examine were announced and implemented between two interview dates, our MPC results are more likely to reflect the fact that the increase in income was unexpected (at least relative to the timing of the previous observation for expenditure). This will imply a larger effect on consumption than in the case where the increase was anticipated.[22] It may also reflect the fact that there is a longer time period between the receipt of the extra money and the interview in these data than there is in the US studies, allowing more time for expenditures to adjust.

The other variables in the regressions are generally correctly signed. As expected, consumption rises with family size, particularly with respect to the number of adults. Higher wealth (as captured by the house value variable) is associated with higher consumption. The coefficient estimate on the dummy variable for credit cards implies that acquiring a credit card (at some time during the sample) is associated with higher consumption thereafter, and vice versa for those that no longer hold a credit card; although this does not imply a causal relationship.[23] The time dummies imply that non-durable consumption was around $456 lower (1.8 per cent) in Wave 6 compared with Wave 7. However, the coefficient on the Wave 5 dummy variable is large, implying a sizeable rise in non-durable expenditure from Wave 5 to Wave 6. This is likely to reflect the effect of some changes to the expenditure questions across these waves.[24]

Footnotes

However, this evidence is not sufficient to be able to accept the PIH outright, since the PIH also implies that households do not respond to anticipated changes in income. [20]

If the excluded expenditure items are in fact durables then the meaning of this fall is difficult to interpret. This is because the relationship between current income and current expenditure on durables is different to that of non-durables. Durable goods provide a stream of consumption benefits, which households will take into consideration when making a purchase. If they receive a permanent increase in income and are able to borrow, they could purchase a durable good immediately, even if the value of that good is greater than the size of the extra income received in each period. [21]

Many other studies have focused on estimating the MPC out of changes in actual income that were anticipated; this is likely to be smaller since at least some (non-liquidity-constrained) households will have responded to the expected effect of the fiscal policy on income when it was announced rather than waiting to receive the extra income. [22]

As mentioned above, we do not control for any effect on consumption of having credit card debt that otherwise needs to be serviced. [23]

Wave 5 was the first year that detailed expenditure data were collected. In Wave 6, additional expenditure categories, mostly durable expenditure items, were added to the survey. The level of aggregation of several non-durable expenditure categories was also reduced in the survey. It is possible that more detailed and comprehensive coverage, as well as greater familiarity with the questions, contributed to the sizeable jump in expenditure observed between Waves 5 and 6. [24]