17.4 Milton Friedman and the Permanent-Income Hypothesis
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In a book published in 1957, Milton Friedman proposed the permanent-income hypothesis to explain consumer behaviour. Friedman’s permanent-income hypothesis complements Modigliani’s life-cycle hypothesis: both use Irving Fisher’s theory of the consumer to argue that consumption should not depend on current income alone. But unlike the life-cycle hypothesis, which emphasizes that income follows a regular pattern over a person’s lifetime, the permanent-income hypothesis emphasizes that people experience random and temporary changes in their incomes from year to year.3
The Hypothesis
Friedman suggested that we view current income Y as the sum of two components, permanent income YP and transitory income YT. That is,
Y = YP + YT.
Permanent income is the part of income that people expect to persist into the future. Transitory income is the part of income that people do not expect to persist. Put differently, permanent income is average income, and transitory income is the random deviation from that average.
To see how we might separate income into these two parts, consider these examples:
Maria, who has a law degree, earned more this year than John, who is a high-school dropout. Maria’s higher income resulted from higher permanent income, because her education will continue to provide her a higher salary.
Sue, a strawberry grower in the Niagara peninsula area in Ontario, earned less than usual this year because dry weather reduced her crop. Bill, a strawberry grower in British Columbia, earned more than usual because the scarcity of strawberries in Ontario drove up selling prices. Bill’s higher income resulted from higher transitory income, because he is no more likely than Sue to have good weather next year.
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These examples show that different forms of income have different degrees of persistence. A good education provides a permanently higher income, whereas good weather provides only transitorily higher income. Although one can imagine intermediate cases, it is useful to keep things simple by supposing that there are only two kinds of income: permanent and transitory.
Friedman reasoned that consumption should depend primarily on permanent income, because consumers use saving and borrowing to smooth consumption in response to transitory changes in income. For example, if a person received a permanent raise of $10,000 per year, his consumption would rise by about as much. Yet if a person won $10,000 in a lottery, he would not consume it all in one year. Instead, he would spread the extra consumption over the rest of his life. Assuming an interest rate of zero and a remaining life span of 50 years, consumption would rise by only $200 per year in response to the $10,000 prize. Thus, consumers spend their permanent income, but they save rather than spend most of their transitory income.
Friedman concluded that we should view the consumption function as approximately
C = αYP,
where α is a constant that measures the fraction of permanent income consumed. The permanent-income hypothesis, as expressed by this equation, states that consumption is proportional to permanent income.
Implications
The permanent-income hypothesis solves the consumption puzzle by suggesting that the standard Keynesian consumption function uses the wrong variable. According to the permanent-income hypothesis, consumption depends on permanent income YP; yet many studies of the consumption function try to relate consumption to current income Y. Friedman argued that this errors-in-variables problem explains the seemingly contradictory findings.
Let’s see what Friedman’s hypothesis implies for the average propensity to consume. Divide both sides of his consumption function by Y to obtain
According to the permanent-income hypothesis, the average propensity to consume depends on the ratio of permanent income to current income. When current income temporarily rises above permanent income, the average propensity to consume temporarily falls; when current income temporarily falls below permanent income, the average propensity to consume temporarily rises.
Now consider the studies of household data. Friedman reasoned that these data reflect a combination of permanent and transitory income. Households with high permanent income have proportionately higher consumption. If all variation in current income came from the permanent component, the average propensity to consume would be the same in all households. But some of the variation in income comes from the transitory component, and households with high transitory income do not have higher consumption. Therefore, researchers find that high-income households have, on average, lower average propensities to consume.
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Similarly, consider the studies of time-series data. Friedman reasoned that year-to-year fluctuations in income are dominated by transitory income. Therefore, years of high income should be years of low average propensities to consume. But over long periods of time—say, from decade to decade—the variation in income comes from the permanent component. Hence, in long time-series, one should observe a constant average propensity to consume, as in fact Kuznets found.
CASE STUDY
Income Taxes Versus Sales Taxes as an Instrument for Stabilization Policy
The permanent-income hypothesis can help us to interpret how the economy responds to changes in fiscal policy. According to the IS–LM model of Chapters 10 and 11, income-tax cuts stimulate consumption and raise aggregate demand, and income-tax increases depress consumption and reduce aggregate demand. The permanent-income hypothesis, however, states that consumption responds only to changes in permanent income. Therefore, transitory changes in income taxes will have only a negligible effect on consumption and aggregate demand. If a change in personal income taxes is to have a large effect on aggregate demand, it must be permanent.
Several income-tax changes in the United States illustrate the relevance of this reasoning. The first example occurred in 1964 when personal income-tax rates were cut by about 18 percent. At the time, the public was told that the growth in U.S. GDP since World War II had been sufficient to permit the government’s revenue needs to be met with lower tax rates. Thus, the tax cut was viewed as permanent, and consumer spending rose markedly. Then, in 1968, the U.S. government wanted to dampen private spending temporarily (while government spending was very high because of the war in Vietnam). The U.S. government introduced a temporary personal income-tax “surcharge” of about 10 percent. Consumption, however, was reduced by only a small amount, just as the permanent-income theory predicts.
The U.S. government tried another temporary tax change in 1975. Because of the recession that followed the Oil Petroleum Exporting Countries (OPEC) crisis, the U.S. government returned to taxpayers some of the taxes already paid in 1974 and reduced income-tax rates for the balance of 1975. Once again, the public realized that this tax break was temporary, and so it had little effect on households’ expectations about their long-run average income. Not surprisingly, households saved a large part of their tax rebates instead of spending them.
In the next episode, President Ronald Reagan introduced a series of tax cuts in the 1981–1984 period, reducing personal income-tax rates by about 23 percent. Households knew that Reagan had campaigned on a promise of smaller government, so the tax cuts were interpreted as likely to be permanent. As a result, these tax cuts did stimulate consumption spending significantly. Finally, in 2008, President George W. Bush enacted a tax rebate which was explicitly designed to be a temporary response to the recession. The estimates showed that 80 percent of these tax rebates were saved—an outcome very close to the predictions of the permanent income hypothesis.
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Another American initiative during the 2009 recession was the Car Allowance Rebate System (CARS), the official name for the cash-for-clunkers program. If households traded in their old car and bought one of a specified list of new environmentally friendly cars—within a relatively short period of time—they received a significant government subsidy toward the new purchase. This program was essentially a temporary sales tax cut for new car purchases. As explained below, this initiative does receive support from the permanent income hypothesis, and the evidence showed that households significantly changed the timing of their car-replacement purchases—bringing them forward in time so that these purchases lessened the magnitude of the recession. But because the program only changed the timing of spending that was likely to take place anyway, it was not a successful initiative for saving the automobile industry or for fundamentally affecting the environment. However, despite contributing very little to these long-term objectives, the program was a success with respect to its short-term objective of providing a stabilization policy during a recession.
How have Canadian authorities responded to these U.S. policy experiments? In the 1978 federal budget, the Canadian government tried to stimulate spending with a general sales-tax cut instead of an income-tax cut. A sales tax does not affect consumption only by raising or lowering households’ estimates of their permanent income. Instead, a temporary sales-tax cut lowers the price of buying goods now, compared to the price in the future. Indeed, the more temporary a sales-tax change is, the more effective it is in changing the timing of people’s spending.4 Thus, sales taxes represent a much more reliable intrument for accomplishing stabilization policy. After all, the whole point of stabilization is to introduce a series of temporary stimuli to aggregate demand.
Unfortunately, until the GST was introduced in 1991, the federal government did not have a retail sales tax with which to implement stabilization policy. The 1978 budget tried to overcome this problem by having the federal government transfer some of its share of the personal income-tax revenue to the provinces in exchange for the provinces agreeing to lower provincial sales-tax rates for a specified time period. Even though an agreement was reached “behind closed doors,” the Quebec government refused to cooperate after the federal budget was made public. Quebec officials claimed that they must resist Ottawa’s meddling in provincial affairs. Unfortunately, the political wrangling that ensued left the federal government uninterested in pursuing agreements of this sort again.
By 1991 the federal government had the GST, which gave the government a more predictable and powerful lever to use in attempts to adjust consumer expenditures for stabilization policy purposes. However, the GST has been very unpopular, and the government has tried to avoid drawing any attention to it by not using it as an instrument for short-run stabilization policy.
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The Conservative government of Stephen Harper—a leader who has an MA degree in economics—has conducted sales-tax policy in a way that is inconsistent with the permanent income hypothesis. In their first two years in office, the Conservatives cut the GST from 7 percent to 5 percent on a permanent basis, and (as we learned in Chapters 7 and 8) this is likely to lower economic growth compared to what would have emerged had they cut personal income taxes permanently instead. Then, in their 2009 budget, when they needed a timely stimulus package, the Conservatives thought that they had no room left to offer a temporary GST cut. This is unfortunate, since this is just what would have been most helpful during the recession. The government chose to focus on the GST when such an initiative was not supported by the permanent income hypothesis, and to ignore the GST when changing it was recommended.
The fact that personal income-tax changes have significant effects on consumer spending only when those changes are expected to be permanent is a dramatic illustration of the importance of the Lucas critique (which we discussed in Chapter 15). As explained there, the prominent economist Robert Lucas has emphasized that predictions of policy impact are quite inaccurate if economists do not focus on how policy affects expectations. The permanent-income hypothesis is a convenient way of organizing our analysis so that the Lucas critique is respected.
The permanent-income hypothesis has received support from numerous episodes other than government fiscal policies. For example, the dramatic stock market crash of 1987 was widely viewed as transitory, and (as the theory predicts) that event had little effect on consumer spending. 