Question

Describe the idea of consumption smoothing, and discuss how it relates to using temporary tax cuts as stimulative fiscal policy during a recession.

Answer 1

Consumption smoothing is an economic concept that describes how an individual balances its spending and savings in order to develop a better standard of living. It states an individuals desire to maintain a secure future by smoothing out their consumption behavior earlier. Therefore, when people have the option to save more, they gain financial liberation and this improves consumption smoothing.

However, during a recession when a tax cut is implemented as a measure to curb recession and encourage spending, the extra income may be saved instead of being spent and this would even lower the demand of goods and services. So when a temporary tax cut occurs, people know that this reduction in tax rate is only for a short time and in the future the tax rates would increase. They would then save more at present to smooth out their consumption in the coming days when the rates go high. Similarly, when there is an temporary increase in tax rates, consumers would reduce their savings, pay the tax but maintain their current consumption. And when the tax rates reduce, they would start saving again. Hence, this consumption smoothing occurs in time and effects the fiscal policy measure during a recession.