Question

Permanent Income Hypothesis holds true (by friedman) then government stabilization policies would be ineffective. However, empirically, the data shows that for example, tax cuts/credits can encourage more consumer spending. How do you explain this?

Answer 1

Permanent income Hypothesis:

It is a theory of consumer spending stating that people will spend money at a level consistent with their expected long-term average income. The level of expected long-term income then becomes thought of as the level of “permanent” income that can be safely spent. A worker will save only if his or her current income is higher than the anticipated level of permanent income, in order to guard against future declines in income.

How It Works:

For example, if an employee is aware that he or she is likely to receive an additional income bonus at the end of a particular pay period or month, it is plausible that said worker’s spending in advance of that bonus may change in anticipation of the additional earnings. However, it is also possible that workers may choose to not increase their spending based solely on short-term windfall. They may instead make efforts to increase their savings, based on the expected boost in income.

Results on the stimulus of alternative tax cut potentia:

The most efficient and effective stimulus proposal would maximize its “bang for the buck.” That is, it would direct as much of the tax cuts as possible to stimulating new consumer spending and/or new business investment in the short run; and it would do the least possible damage to long-term fiscal prospects and hence minimize any upward pressure on interest rates. Temporary rebates to individuals and temporary business subsidies for new investment fit these principles. A package with substantial long-term revenue costs, on the other hand, could do as much harm as good: It would raise interest rates, which would offset much of the direct benefits of any stimulus by reducing business and housing investment, as well as consumption that is affected by interest rates or stock market values. Many of the stimulus proposals currently being considered do little or nothing to address the need to stimulate the economy in the short-run, and would exacerbate long-term fiscal problems. Proposals to cut tax rates on capital gains or on corporate income are particularly problematic along these dimensions. Such proposals may be worth discussing in other contexts, but they clearly represent the wrong policy response at the current time.   

Tax cut is an important stimulus to consumer spending. But an analysis of the effects of earlier income tax cuts suggests that the consumer response to such initiatives is, in fact, quite variable. Two conclusions stand out: First, consumers will be more likely to boost spending if the change in tax liabilities is permanent. Second, consumers will wait to increase spending until a tax change affects their take-home pay.

The effect of tax cuts:

Lower income tax rates rise the spending power of consumers and can increase aggregate demand, leading to higher economic growth (and possibly inflation). On the supply side, income tax cuts may also rise incentives to work – leading to higher productivity.

The Effect of Credit on Spending Decisions:

Consumer Credit:

Consumer credit allows people to purchase goods and services immediately and repay the costs over time. It offers consumers flexibility in spending and, in some cases, perks and rewards. However, consumer credit can also tempt some to spend beyond their means.

Consumer credit is defined as a personal debt taken on to purchase goods and services. A credit card is one form of consumer credit.

Although any type of personal loan could be labelled consumer credit, the term is commonly used to describe unsecured debt that is taken on to buy everyday goods and services. It is not usually used to describe the purchase of a house, for example, which is considered a long-term investment and is usually purchased with a secured mortgage loan.

Advantages of Consumer Credit:

Consumer credit helps consumers to get an advance on income to buy products and services. In an emergency, such as a car breakdown, that can be a lifesaver. Because credit cards are relatively safe and easy to carry, America is increasingly becoming a cashless society in which people routinely rely on credit for purchases large and small. It offers consumers flexibility in spending and, in some cases, perks and rewards. So that credits encourage consumers to spend more.

Revolving consumer credit is a highly lucrative industry. Banks and financial institutions, department stores, and many other businesses offer consumer credit to their customers.

The single biggest advantage of consumer credit is its financial flexibility. In the days before widespread access to credit cards and other consumer lending options, people often had to save for years to make major purchases. If your car broke down or you need a new refrigerator, it could hamper your ability to make ends meet. Credit helps a consumers to spread out major costs over the course of months or years so they don't have to choose between buying a new transmission and putting food on the table.

Summary: in this context one point is clear that tax cuts and credits can encourage more consumer spending. Tax cut is an important stimulus to consumer spending and Consumer credit allows people to purchase goods and services immediately and repay the costs over time.