Rational Illiquidity and Excess Sensitivity: Theory and Evidence from Income Tax Withholding and Refunds
There is a tight relationship between having low liquidity and a high marginal propensity to consume both in theoretical models and in econometric evidence about behavior. This paper analyzes the theory and behavior surrounding income tax withholding and refunds. It develops a model where rational cash management with asymmetric cost of increasing or decreasing liquidity endogenizes the relationship between illiquidity and excess sensitivity. The analysis accounts for the finding that households tend to spend tax refunds as if they were liquidity constrained despite the fact that they could increase liquidity by reducing withholding. The model’s predictions are supported by evidence from a large panel of individuals.
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Document Object Identifier (DOI): 10.3386/w25757