London Business School’s professor Paolo Surico and Michele Andreolli, a fifth year PhD students in Economics at LBS, have written a discussion paper, published by the Centre for Economic Policy Research (CEPR). Less is More: Consumer Spending and the Size of Economic Stimulus Payments is a study of the consumption response to unanticipated transitory income gains of different size, using hypothetical questions from the Italian Survey of Household Income and Wealth (SHIW).
The paper contends that families with low cash-on-hand demonstrate a higher Marginal Propensity to Consume (MPC) out of small gains, while affluent households exhibit a higher MPC out of large gains. The spending behaviour of low-income families is consistent with the presence of borrowing constraints whereas the consumption pattern of top earners can be accounted for by non-homothetic preferences on non-essential goods and services. Surico and Andreolli’s results suggest that, for a given level of public spending, a fiscal transfer of smaller size paid to a larger base of low-income households leads to a significantly larger increase in aggregate consumption than a larger transfer paid to a smaller base.
The paper asserts: “The global pandemic of 2020-21 has attracted renewed attention on how fiscal policy could exert its maximum impact on aggregate consumption. A main dimension of this debate has centred around the size of the stimulus payments to households and how this relates to the Marginal Propensity to Consume (MPC) along the income distribution. If, on the one hand, the MPC was small (with the windfall mostly used to save or repay debt, Mian and Sufi, 2010, Dynan, 2012) and invariant to income, then a large and untargeted fiscal transfer would be needed to generate a significant boost to aggregate consumption. If, on the other hand, the MPC was higher for specific groups of earners, then a small and targeted fiscal transfer could deliver the same aggregate effects on consumer spending, but at a significantly lower cost for public finances."
In the paper, Surico and Andreolli compare the MPC out of small and large income gains for the very same household. They tackle this by exploiting a unique set of questions in the SHIW, which ask respondents how much they would spend in response to an increase in their disposable resources as large as one month and one year of their income, respectively. The advantage of this approach is twofold. First, by focusing on within-household variation only, one can be confident that any MPC heterogeneity does not reflect unobserved heterogeneity. Second, the difference in the magnitude of the two income gains is not only independent from individual characteristics but also sufficiently large to elicit any possible heterogeneity in spending due to the size of the windfall.
The empirical findings drawn from the report can be summarised as follows. First, the MPC out of small income changes is a negative function of household resources whereas the MPC out of large income changes display a slightly positive gradient. Second, families with low cash-on-hand exhibit a higher MPC out of the smaller gains whereas affluent households are characterised by a higher MPC out of the larger windfalls. Third, the higher MPCs out of large gains are concentrated in the North, which is the richest part of the country. Fourth, affluent households devote a significantly larger share of their food spending on eating out —which we interpret as a proxy for the importance of non-essential spending in the consumption basket— and the budget share spent on luxury goods and services is a significant predictor of a higher MPC, especially for large gains.
Surico and Andreolli’s favoured interpretation is that borrowing constraints are more likely to be a significant determinant of spending among households with low cash-on-hand and therefore these are responsible for the empirical findings that the MPC out of small income gains is higher than out of large gains among poor families as well as that the MPC out of small gains is a negative function of disposable resource. Among affluent households, however, liquidity considerations are less likely to drive their expenditure and non-essential spending is much more frequent. Accordingly, non-homothetic preferences on luxury consumption can provide a rationale for the empirical findings that families with high cash-on-hand report a higher MPC out of larger income gains and the MPC depends positively on household resources when the windfall is large.
As for policy implications, we simulate a number of fiscal experiments that vary either the size of the transfer to households or the way in which the stimulus package is financed. Based on the MPC heterogeneity across shock size and household resources documented above, our simulations reach three main conclusions. First, for a given level of public spending, a smaller payment to a larger fraction of low cash-on-hand households produces a significantly larger increase in aggregate consumption than a larger transfer paid to a smaller group of disadvantages families. Second, raising taxes among affluent households to finance the stimulus package produces a positive and economically significant net effect on aggregate consumption when the fiscal transfers are small. Finally, the distortionary effects of taxation are minimised by levying a smaller tax increase on the wealth and income of a larger share of affluent households rather than a higher tax hike for a smaller fraction of top earners.
To read the full report, Less is more: consumer spending and the size of economic stimulus payments by Michele Andreolli and Paolo Surico download the paper here (and by registering with the CEPR if necessary).