Risky Habits and the Marginal Propensity to Consume Output of Permanent Income, or, How Much Would a Permanent Tax Cut Boost Japanese Consumption?

Christopher Carroll

International Economic Journal, 2000, vol. 14, issue 4, 1-40

Abstract: Papers in a variety of disparate literatures have recently suggested that habit formation in consumption may explain several empirical puzzles, ranging from the level and cyclical variability of the equity premium (Abel, 1990, 1999: Constantinides, 1990; Jerman, 1998; Campbell and Cochrane, 1999) to the 'excess smoothness' of aggregate consumption (Fuhrer, 2000) to the apparent fact that increases in economic growth cause subsequent increase in aggregate saving rates (Carroll and Weil, 1994: Bosworth, 1993; Attanasio, Picci, and Scorceu, 2000; Rodrik, 1999; Layza, Schmidt-Hebbel, and Serven, 2000) This paper examines an implication of these models that has mostly been overlooked: Habits strong enough to solve these puzzles imply an immediate marginal propensity to consume out of permanent shocks of much lees than one. When the model is calibrated to roughly match the rise in the Japanese saving rate over the postwar periode, it implies that the immediate MPC out of Permanent tax cuts may be as low as 30 percent, suggesting that calls for a permanent income tax cut as a quick means of stimulating aggregate demand in Japan may be misguided. [D11, D81, D91, E10, E17, E21, H31]

Date: 2000
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DOI: 10.1080/10168730000000033

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