Rational Illiquidity and Consumption: Theory and Evidence from Income Tax Withholding and Refunds

46 Pages Posted: 15 Apr 2019 Last revised: 9 Sep 2022

See all articles by Michael Gelman

Michael Gelman

Claremont McKenna College

Shachar Kariv

University of California, Berkeley - Department of Economics

Matthew D. Shapiro

University of Michigan at Ann Arbor - Department of Economics; National Bureau of Economic Research (NBER)

Dan Silverman

Arizona State University (ASU) - W.P. Carey School of Business

Date Written: April 2019

Abstract

Having low liquidity and a high marginal propensity to consume (MPC) are tightly linked. This paper analyzes this linkage in the context of income tax withholding and refunds. A theory of rational cash management with income uncertainty endogenizes the relationship between illiquidity and the MPC, which accounts for the finding that households tend to spend tax refunds as if they valued liquidity, yet do not act to increase liquidity by reducing their income tax withholding. The theory is supported by individual-level evidence, including a positive correlation between the size of tax refunds and the MPC out of those refunds.

Suggested Citation

Gelman, Michael and Kariv, Shachar and Shapiro, Matthew D. and Silverman, Dan, Rational Illiquidity and Consumption: Theory and Evidence from Income Tax Withholding and Refunds (April 2019). NBER Working Paper No. w25757, Available at SSRN: https://ssrn.com/abstract=3372061

Michael Gelman (Contact Author)

Claremont McKenna College ( email )

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Shachar Kariv

University of California, Berkeley - Department of Economics ( email )

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Berkeley, CA 94720-3880
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Matthew D. Shapiro

University of Michigan at Ann Arbor - Department of Economics ( email )

and Survey Research Center
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National Bureau of Economic Research (NBER) ( email )

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Dan Silverman

Arizona State University (ASU) - W.P. Carey School of Business ( email )

Tempe, AZ 85287-3706
United States

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