a) Let\'s use the model of intertemporal consumption choice to consider the beha
ID: 1190605 • Letter: A
Question
a) Let's use the model of intertemporal consumption choice to consider the behaviour of a hypothetical individual. This person is not liquidity constrained and is endowed with an exogenous amount of income in each of the current and the future periods. Assume the person must pay an income tax; that is assume he must pay fraction t of his income in the form of tax.es. Thus if he has of Y dollars then his tax bill is tY dollars and his after-tax income is (1-t)Y dollars. Use the model as an aid to showing that if it is announced the income tax rate imposed on income will increase at some point in the future, this will influence current consumption expenditures. As always, your diagram should be large, neatly drawn, well-labelled and fully explained.
b) On the basis of your answer to part (a), speculate on what this suggests for how and when policy-makers make announcements of policy changes.
c) Suppose you win $100,000. What does the permanent income hypothesis suggest will happen to your consumption spending? Explain.
Explanation / Answer
If the policymakers decide to increase the taxes in the future then the current consumption shoots up because the taxes collected in future will be a higher proportion of the income left for future consumption. So there is no point saving up a large amount for future consumption and giving out hefty taxes. Under the assumptions of effective market hypothesis the moment information is given out it is automatically absorbed in the market. Thus if the government spells out right now they will increase the taxes sometime in future then people immediately adjust their consumption patterns and reduce future consumption. Thus on part of the government it will be better if it declares the tax rate change later in future, then it can collect much higher revenue. According to the permanent income hypothesis consumption spending is only affected by the increase in permanent income. Here an increase $100,000 does not lead to a permanent rise in income and thus is not incorporated as a change in consumption spending.
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