How Will Consumers Change Their Spending?

 | Jan 09, 2013 | 4:00 PM EST
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In a follow-up to my recent article about how the end of the payroll tax cut might affect consumer spending, research from the New York Fed this week provides numbers we can use. The economy is growing, and it has the potential to improve once we get past the trio of debates in the next couple of months on spending cuts, the debt ceiling and funding the government's operations. Those debates can turn into political paralysis, hurting both the economy and the markets, and represent one risk of what might happen from upcoming legislative actions.

However, one big risk that I see from legislation already passed is how consumers might react to smaller paychecks. Recall that the payroll tax cut basically gave nearly 155 million workers a temporary raise of as much as 2%. That pay cut has now ended, with the payroll tax rate returning to 6.2% from 4.2% for incomes up to $110,100 in 2012. For a worker earning $50,000 a year, that amounts to $1,000 a year, or $84 a month. Economy-wide, it added $112 billion to workers' paychecks in 2011.

How will this affect consumer spending? Well, that depends on what consumers did with the money and what they might do without it. The new research indicates that consumers actually spent much more of it than they intended. And they intend to cut back spending by an even greater amount with the end of the tax cut than they increased their spending in the first place.

Specifically, consumers were surveyed about the spending cuts ex-ante, when the payroll cuts took effect back in in early 2011, and then ex-post, in mid-December 2011, when they had been receiving the additional funds. Ex -ante, very few (12%) reported intending to spend the funds, and consumers expected the dollar amount of their spending from the payroll tax cuts would be 13.7% of the tax cuts.

Instead, after consumers received the funds in their paycheck, 35% of people surveyed reported spending the funds, with the 35.9% of the funds being spent in dollar terms. Initial projections were that lower-income consumers (who presumably had tighter budgets) spend more and better-off consumers would save more of their tax cuts. What happened was the opposite: Lower income consumers used more of the tax cuts to pay down debt, while better-off consumers spent more of it.

Typically with tax cuts, consumers view these effects as temporary and tend to save more of these amounts. That corresponds to the initial survey, but it isn't quite what happened. Why did people spend more than expected? The researchers believe that people viewed these cuts as income increases, rather than tax cuts, given their income (not payroll) tax rates did not change. Thus, they put these funds into a different mental accounting bucket that permitted them, psychologically speaking, to spend more of the tax cuts than planned.

In fact, 51.7% of those originally intending to save the funds, and 18.7% of those who had planned to pay down debt with the funds, actually spent the money instead. (Seventy-one percent of those who planned to spend the funds actually did so.)

Why do we care about this research, anyway? The corollary of what people did with the tax cut when they received them may tell us what they might do when those tax cuts are taken away. Alas, the upshot is that the people surveyed intend to cut spending by an even greater amount -- by 71.4% of the initial payroll tax cut – now that the tax cuts are not extended. They may see this as a take-home pay cut, not the end of what was a temporary payroll tax cut. These planned spending cuts are quite a bit greater than the 35.9% increase in spending that consumers actually did when they got their payroll tax cut.

In aggregate dollars, that works out to be a spending reduction of about $83 billion, or roughly 0.5% of GDP. That is not enough to tip the economy into recession, of course, but is does represent a headwind. We will have to wait to see how the debates on government spending cuts play out in the months ahead before we can flesh out the full economic response to budgetary challenges.

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