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

55 Pages Posted: 15 Apr 2019

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

There is a tight relationship between having low liquidity and a high marginal propensity to consume both in theoretical models and in econometric evidence about behavior. This paper analyzes the theory and behavior surrounding income tax withholding and refunds. It develops a model where rational cash management with asymmetric cost of increasing or decreasing liquidity endogenizes the relationship between illiquidity and excess sensitivity. The analysis accounts for the finding that households tend to spend tax refunds as if they were liquidity constrained despite the fact that they could increase liquidity by reducing withholding. The model’s predictions are supported by evidence from a large panel of individuals.

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Suggested Citation

Gelman, Michael and Kariv, Shachar and Shapiro, Matthew D. and Silverman, Dan, Rational Illiquidity and Excess Sensitivity: 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 )

500 E. Ninth St.
Claremont, CA 91711-6420
United States

Shachar Kariv

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

549 Evans Hall #3880
Berkeley, CA 94720-3880
United States

Matthew D. Shapiro

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

and Survey Research Center
611 Tappan Street
Ann Arbor, MI 48109-1220
United States
313-764-5419 (Phone)
313-764-2769 (Fax)

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
United States
313-764-5419 (Phone)
313-764-2769 (Fax)

Dan Silverman

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

Tempe, AZ 85287-3706
United States

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