Rational Illiquidity and Consumption: Theory and Evidence from Income Tax Withholding and Refunds

Abstract

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.