Testing Economic Theories of Consumption Behavior

The Life-Cycle/Permanent Income Hypothesis (LCPIH) is the standard economic framework for understanding household spending and saving decisions over time. While the model provides a number of testable implications, the primary predictions involve how households will choose to consume in response to changes in income. When income changes are anticipated, the model predicts that consumption will not change contemporaneously, as households base consumption decisions in each period on expected lifetime wealth as opposed to current income. Unexpected income shocks, which alter lifetime resources, will result in consumption changes. Income changes can also be delineated between transitory and permanent income changes. Transitory income changes (e.g., a single-year windfall or loss) will only have a small impact on consumption as these changes have a small effect on lifetime resources. Permanent income changes, which alter income in all future years, will have a much larger effect on household consumption.

The CE has long been the unique data source that has enabled researchers to test predictions of the LCPIH using a broad set of consumption measures. Attanasio and Weber (1995) found that using microdata containing all expenditure measures for each household dramatically alters the empirical findings of previous tests of the LCPIH. First, the authors found that whereas many prior studies using aggregate expenditure (e.g., national time-series) data yield results inconsistent with the LCPIH, using microdata to create aggregates across households in a way that is consistent with the underlying economic theory results in estimates that are consistent with the model. Second, whereas past studies that had limited consumption measures (in many cases, just food consumption) rejected the LCPIH, testing the model using the full set of household consumption available in the CE could not reject the model.

Subsequent studies using the CE focused on clearly predictable changes in household income to avoid the many potential statistical pitfalls that may arise when predicting income changes for households using econometric methods. Some studies continue to find results that are consistent with the LCPIH. For example, Hsieh (2003) found that Alaskan residents, who receive large, annual oil dividend payments each fall, the amounts of which are pre-announced earlier in the year, do not exhibit a change in consumption upon receiving these payments. However, other studies find estimates that reject the LCPIH. Parker (1999) found that household consumption increases in response to intra-year paycheck increases due to households hitting the maximum annual Social Security tax limit, after which they no longer pay Social Security tax for that calendar year. Souleles (1999) found that household consumption increases in response to income tax refund



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