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Liquidity Constraints, Fiscal Policy, and Consumption

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Liquidity Constraints, Fiscal Policy, and Consumption R. GLENN HUBBARD Northwestern University KENNETH L. JUDD Northwestern University Liquidity Constraints, Fiscal Policy, and Consumption TAX POLICY AND TAX REFORM are importantitems on the currentpolicy agenda. In evaluating alternative tax policies, decisionmakers must consider both their normativeand positive impact; in particular,they must examinethe effects of competingpolicies on the overall well-being of the taxpayers and on various indexes of economic activity, in both the shortrun and long run. Basic to understandingthe impact of tax policy is analysis of the relationshipbetween taxationand taxpayers'decisions aboutconsump- tion, saving, and work effort. Such analysis is especially sensitive to assumptionsmade regardingindividuals' abilities to use capitalmarkets to transferincome across time. By the same token, we thinkthat policy simulationmodels that ignore "liquidity constraints" result in flawed tax policy analysis. In this paper we analyze the impact of liquidity constraints on consumption functions and use the resulting view of aggregate demand to address two categories of tax and fiscal policy issues. The first issue is developinga tax system that least reduces taxpayer well-beingfor the amount of lifetime revenue extracted. Recent appli- cations of theoreticallybased models of individualbehavior have facili- We aregrateful to JohnSimpson and Nicolas Williamsfor excellentresearch assistance and to MervynKing, LaurenceKotlikoff, and membersof the BrookingsPanel and the Faculty Research Seminarat the John F. Kennedy School of Governmentfor helpful comments.Financial support from Northwestern University is acknowledged. 1 2 Brookings Papers on Economic Activity, 1:1986 tated comparisonsof the effects of alternativepolicies. Indeed, much of the present debate over the relative reliance on various tax bases and the optimaldegree of progressivityof the income tax has been reflected in studies using policy-simulationmodels. I These models generallyassume that individualsor households maxi- mize well-being over their lifetime, subject only to the restrictionthat the present value of consumptionis no greaterthan the present value of income. The models then assess how tax policies can alter the rewards to saving and working, thereby distortingintertemporal choices about consumptionand work effort. But modelswith an overalllifetime budget constraint ignore the many restrictions on individuals' ability to shift income in a world of capital market imperfections, restrictions that substantiallyaffect those intertemporalchoices.2 Taking into account the effect of liquidityconstraints affects the calculationof the welfare costs of taxationsubstantially; prevailing arguments, based on "perfect market"models, againstcapital taxation or progressiveincome taxation and in favor of wage and consumptiontaxation must be substantially mutedand often reversed.3 The second issue that we examine is the importance of liquidity constraintsfor the debateover the impactof temporarytax cuts financed by debt. We show that liquidity-constraintconsiderations are quantita- tively more importantthan the frequently discussed "finite-horizon" considerationsthat focus on how debt shifts the tax burdenonto future generations.We also findthat when both considerations are incorporated 1. See, for example, Lawrence H. Summers, "CapitalTaxation and Accumulation in a Life Cycle GrowthModel," AmericanEconomic Review, vol. 71 (September1981), pp. 533-44; Alan J. Auerbachand LaurenceJ. Kotlikoff, "NationalSavings, Economic Welfare,and the Structureof Taxation,"in MartinFeldstein, ed., BehavioralSimuilation Methods in Tax Policy Analysis (University of Chicago Press, 1983), pp. 459-93; Alan J. Auerbach,Laurence J. Kotlikoff,and JonathanSkinner, "The EfficiencyGains from Dynamic Tax Reform," InternationalEconomic Review, vol. 24 (February1983), pp. 81-100; and E. John Driffilland Harvey S. Rosen, "Taxationand Excess Burden:A Life Cycle Perspective," InternationalEconomic Review, vol. 24 (October 1983), pp. 671-83. 2. See, for example, the earlieranalysis by JamesTobin and WalterDolde, "Wealth, Liquidity and Consumption," in Consumer Spending and Monetazy Policy: The Linkages (FederalReserve Bank of Boston, 1971), pp. 99-146. 3. This issue is discussed with respect to the social security payrolltax in R. Glenn Hubbardand KennethL. Judd, "Social Securityand IndividualWelfare: Precautionary Saving, Liquidity Constraints,and the Payroll Tax," WorkingPaper 1736 (National Bureauof Economic Research, October 1985). R. Glenn Hubbard and Kenneth L. Judd 3 into the consumption function, debt-financed tax cuts of the type observedin the post-WorldWar II erado not substantiallyalter aggregate consumption. In this light, the plan of the paperis as follows. First, we elaborateon the potential macroeconomic importanceof liquidity constraints and their role in tax policy analysis in life-cycle consumptionmodels. We then develop a simplelife-cycle model to examinethe effects of liquidity constraintson measures of nationalsaving and individualwelfare. We focus on the life-cycle model because of its easy applicabilityto fiscal policy analysis. Use of this model introduces no bias a priori in our examinationof the effects of liquidityconstraints, since the life-cycle modelunder rational expectations and with perfect capital markets offers fiscal policy little scope in influencingconsumption. We consider three major applications:the relative welfare costs of capital versus labor income taxation, effects of progressive versus proportionalincome taxation,and effects of temporarytax changes on consumption. Liquidity Constraints and Consumption The effect of liquidity constraints, defined in various ways, on consumer spendinghas been considered in many studies.4In response to Robert Lucas's critique of econometric policy evaluation, Robert Hall proposed the "Euler equation" approachto testing the sensitivity of consumption to current income changes.5 In Hall's model, to be 4. For a general discussion, see Tobin and Dolde, "Wealth, Liquidity and Con- sumption";Alan S. Blinder,"Intergenerational Transfers and Life Cycle Consumption," American Economic Review, vol. 66 (May 1976, Papers and Proceedings, 1975), pp. 87-93; Walter Dolde, "Capital Markets and the Short Run Behavior of Life Cycle Savers," Journal of Finance, vol. 33 (May 1978), pp. 413-28; and Fumio Hayashi, "Tests for LiquidityConstraints: A Critical Survey," WorkingPaper 1720 (National Bureauof EconomicResearch, October 1985). 5. Robert E. Lucas, Jr., "Econometric Policy Evaluation:A Critique," in Karl Brunner and Allan H. Meltzer, eds., The Phillips Curve and Labor Markets, Carnegie- Rochester Conference Series on Public Policy, vol. 1 (Amsterdam:North-Holland, 1976),pp. 19-46; RobertE. Hall, "StochasticImplications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, vol. 86 (December 1978),pp. 971-87. For a discussion of econometricproblems (in particular, aggregationissues) with Euler equation methods, see Angus S. Deaton, "Life-Cycle Models of Consumption:Is the Evidence Consistent with the Theory?" (Princeton University, July 1985). 4 Brookings Papers on Economic Activity, 1:1986 consistent with the permanent-incomehypothesis under rational expec- tations(with no borrowingrestrictions), conditional on laggedconsump- tion, expected consumption should be independent of other lagged information. Other empirical studies find consumer spending to be sensitive to income changes.6 Findingsof excess sensitivityof consump- tion to changes in disposableincome are corroboratedin a study of food expendituresby Hall and FredericMishkin.7 Ouranalysis is predicatedon the idea that this excess sensitivity can be traced to the operationof liquidityconstraints, the aggregateimpor- tance of which for the United States is amply illustratedby historical evidence. BradfordDeLong and Lawrence Summers note that from 1899 to 1916, "essentially all consumption was done by liquidity- constrainedconsumers.' '8 Their findingsfor the entire pre-WorldWar II period broadly support this conclusion and suggest the possibility, whichwe considerin oursimulation exercises, thatforced lifetime saving (thatis, underconsumption)by consumerswho are liquidityconstrained may be an importantcomponent of total saving. For example, Alan Auerbachand LaurenceKotlikoff note that personalsaving rates in the United States exceeded 20 percent duringthe 1880s-before the availa- bility of consumercredit and the pursuitof stabilizationpolicy .9 FumioHayashi finds that liquidity-constrainedconsumers accounted for approximately20 percent of all consumptionin post-World War II United States.10 In a separateeffort using microeconomicdata, Hayashi 6. MarjorieA. Flavin, "The Adjustmentof Consumptionto ChangingExpectations about FutureIncome," Journal of Political Economy, vol. 89 (October 1981),pp. 974- 1009;Fumio Hayashi, "The PermanentIncome Hypothesis:Estimation and Testing by InstrumentalVariables," Journal of Political Economy, vol. 90 (October1982), pp. 895- 916; Lars Peter Hansen and KennethJ. Singleton,"Generalized Instrumental Variables Estimationof NonlinearRational Expectations Models," Econometrica, vol. 50 (Sep- tember 1982), pp. 1269-86; Alan S. Blinder and Angus Deaton, "The Time Series ConsumptionFunction Revisited," BPEA, 2:1985, pp. 465-511. 7. Robert E. Hall and Frederic S. Mishkin, "The Sensitivity of Consumptionto TransitoryIncome: Estimatesfrom Panel Data on Households," Econometrica, vol. 50 (March1982), pp.
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