Rational Illiquidity and Excess Sensitivity: Theory and Evidence from Income Tax Withholding and Refunds

Michael Gelman, Dan Silverman, Matthew Shapiro and Shachar Kariv
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Dan Silverman: Arizona State University
Shachar Kariv: University of California, Berkeley

No 542, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: Nearly a third of all personal income tax collected by the US, government is later returned in the form of tax refunds; and households tend to spend disproportionately from those refunds. This paper develops a theory of liquid assets management that explains why households voluntarily reduce liquidity by overwitholding, but then spend in response to the liquidity provided by tax refunds. Liquidity constraints that arise endogenously when income is uncertain and when adjusting tax payments is not frictionless explain these behaviors. Tax refunds tend to arrive in circumstances where income is lower than expected, so liquidity is low and the MPC is endogenously high. The average amount of income not subject to withholding and the average annual fluctuations in that income are more than sufficient to explain the size of tax refunds, and microevidence supports central mechanisms of the model.

Date: 2019
New Economics Papers: this item is included in nep-dge and nep-pub
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