Can Tax Rebates Stimulate Consumption Spending in a Life-Cycle Model? (Working Paper 2011-02)

This paper presents a life-cycle model with earnings risk, liquidity constraints, and portfolio choice over tax-deferred and taxable assets to evaluate changes to household consumption in response to transitory, anticipated income shocks, such as the 2001 federal income tax rebate. Households optimally hold a large share of savings in tax-deferred assets, which are encumbered by withdrawal penalties, and choose to relinquish some taxable precautionary savings in exchange for higher after-tax returns. The model predicts an increase of several percentage points in the marginal propensity to