Rational Illiquidity and Consumption: Theory and Evidence from Income Tax Withholding and Refunds
Having low liquidity and a high marginal propensity to consume (MPC) are tightly linked. This paper analyzes this linkage in the context of income tax withholding and refunds. A theory of rational cash management with income uncertainty endogenizes the relationship between illiquidity and the MPC, which accounts for the finding that households tend to spend tax refunds as if they valued liquidity, yet do not act to increase liquidity by reducing their income tax withholding. The theory is supported by individual-level evidence, including a positive correlation between the size of tax refunds and the MPC out of those refunds.
We thank William Boning, James Hines, Damon Jones, Joel Slemrod, Basit Zafar, and participants at seminars for helpful comments. This research is supported by a grant from the Alfred P. Sloan Foundation. Shapiro acknowledges additional support from the Michigan node of the NSF-Census Research Network (NSF SES 1131500). The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Michael Gelman & Shachar Kariv & Matthew D. Shapiro & Dan Silverman, 2022. "Rational Illiquidity and Consumption: Theory and Evidence from Income Tax Withholding and Refunds," American Economic Review, vol 112(9), pages 2959-2991. citation courtesy of