The Effect of Tax Changes on Consumer Spending

Abstract

The near-term effect of tax cuts on the economy has generated considerable interest among policymakers and economists this year. Much of the discussion has centered on the question whether tax cuts are an effective spur to consumer spending. This question was at the heart of the legislative debate over the Bush Administration’s tax package, and it continues to stir controversy as various economic stimulus plans are put forward in the wake of the September 11 terrorist attacks. In this edition of Current Issues, we cast new light on the debate by reviewing how past tax changes affected consumer spending. Specifically, we look at the impact of major federal income tax changes in 1968, 1975, and 1982 and the effect of changes in Social Security payroll taxes and benefits. Our study begins with a look at what economic theory predicts about consumer responses to tax cuts, and throughout the analysis, we compare actual responses with those implied by theory. We find that while almost all of the tax and benefit changes examined in the study prompted changes in consumer spending, the magnitude of the responses varied greatly. In conformity with economic theory, the spending effect was larger when the tax change was legislated to have a permanent effect on tax liabilities. Contrary to theory, however, households adjusted their spending only after tax changes took effect. This finding challenges the standard assumption that forward-looking consumers will alter their spending behavior in anticipation of an income change.