Taxation and consumption: The reaction of consumers to an unanticipated tax change

Bernd Hayo, Professor at the University of Marburg discusses the reaction of consumers to an unanticipated tax change

Fiscal policy, the increase and decrease of either government expenditure or taxes, is an important macroeconomic stabilisation instrument. Increasing taxes is assumed to decrease consumer spending, with the reverse response expected for decreasing taxes.

Economic research on the effects of tax changes tends to use theoretical models or statistical estimations, which often suffer from assuming non-realistic consumer responses or weak identification of the policy change. Following related research on the U.S. (see, e.g. Shapiro and Slemrod 1995); Hayo and Uhl (2017) employ a different approach by directly asking consumers about their behaviour to more accurately investigate the real-world consequences of increased taxation.

In Germany, private final consumption expenditure accounts for approximately 60% of gross domestic product (GDP), suggesting that consumption responses are highly relevant when analysing the macroeconomic consequences of tax changes. Consumption responses to tax changes represent an important feature of public debate about the effectiveness of fiscal stimulus but are also the core of the transmission of fiscal policy shocks in most macroeconomic models. Understanding responses to tax changes in Germany are, therefore, important for both economic policy and academic research.

Statutory pension insurance in Germany is a pay-as-you-go system, where current contributions are used to pay for current pensions. The pension insurance contribution rate is divided between employers and employees. It is financed by a proportionate tax on monthly income. Future pension entitlements depend on the income of the insured but not on the contribution rate.

At the beginning of 2013, about two months before the survey was conducted, contribution rates to the statutory pension insurance system in Germany were reduced from 19.6 % to 18.9%, thus lessening the overall tax burden of employees and employers. The rate change needed to be implemented because the statutory pension insurance is not allowed to accumulate a substantial surplus, i.e. it can be interpreted as an exogenous German tax shock of average size.

Hayo and Uhl’s (2017) research uses a representative survey of the German population, with the analysis focusing on those respondents contributing to the statutory pension insurance system. When asking respondents about whether they planned to save or spend the additional household income received from the tax reduction, 55% stated that they intended to increase spending. These results suggest that taxation can significantly affect consumption.

Hayo and Uhl (2017) also investigate economic and socio-demographic factors associated with consumption. The respondents’ perception that the tax change was either temporary or permanent was not a significant explanatory variable at the individual level, suggesting that both types of tax changes have similar effects on consumer behaviour. Expectations of future economic outcomes, however, were statistically insignificant, indicating that variation in expected income over the business cycle does not alter the impact of tax changes. Factual knowledge of the budget deficit, interest rate and inflation rate data was also not worth considering statistically.

It is interesting to investigate whether economic knowledge is systematically associated with consumption responses to tax changes, as this is a typical assumption made in macroeconomic theory. For instance, intertemporal utility maximisation requires economic agents to know the actual value of real interest rates. Likewise, Ricardian equivalence is based on the idea that rational agents take the government’s intertemporal budget constraint into account.

When Hayo and Uhl (2017) analyse factual knowledge, they discover that only 9% of survey respondents were able to correctly identify the previous year’s budget deficit, 36% chose the correct long-term interest rate and 66% selected the correct rate of inflation.

Judging from these findings, it seems that consumers in Germany are not particularly well-informed about macroeconomic variables that they are assumed to know about in widely-used macroeconomic models. Instead, economic knowledge or ‘economic literacy’ does not appear to be associated with different consumption behaviour in response to tax changes.

In the survey, individuals who perceived the current return on savings to be low, even if they did not know the actual interest rate level, were much more likely to spend the additional money from the tax change. This highlights the fact that interest rates are an important determinant of consumption and saving decisions. Such findings are also indicative of the current low level of interest rates resulting in lower savings.

In addition, those with a high level of household income were 14% more likely to increase spending in response to tax changes. The proportion of individuals replying ‘mostly spend’ was 49% for low-income households, 57% for medium-income households and 60% for high-income households. This contradicts traditional wisdom going back to John Maynard Keynes that low-income households are characterised by a higher marginal propensity to consume.

Finally, individuals that can be defined as ‘Ricardian consumers’ (here: those who save more when public debt increases) were significantly less likely to spend the additional money. However, using a more sophisticated way of identifying Ricardian consumers, Hayo and Neumeier (2017) demonstrate that this group showing rational behaviour in the way typically assumed in economic models constitute only a minority of German consumers.

Summarising the discussion, three contributions to the research literature can be identified. First, perceptions of the tax change being temporary or permanent had no significant effect on consumption. Second, the evidence is provided that individuals, who perceive the attractiveness of saving to be low, have a higher propensity to spend. Third, households with higher income actually appear to have a higher propensity to consume than lower income household after controlling for other factors, which stands in sharp contrast to conventional wisdom.

References

Hayo, B. and F. Neumeier (2017), The (In) Validity of the Ricardian Equivalence Theorem–Findings from a Representative German Population Survey, Journal of Macroeconomics 51, 162-174.

Hayo, B. and M. Uhl (2017), Taxation and Consumption: Evidence from a Representative Survey of the German Population, Applied Economics 49, 5477-5490.

Shapiro, M.D. and J. Slemrod (1995), Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding, American Economic Review 85, 274-283.mar

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Bernd Hayo

Professor

University of Marburg

Tel: +49 (0)6421 282 3091

hayo@wiwi.uni-marburg.de

www.uni-marburg.de/en/fb02/research-groups/economics/macroeconomics