Where Will the Tax Rebates Go?

April 11, 2008

By Lars Perner

The tax rebates the IRS will issue starting next month are targeted primarily at low- to middle-income consumers. These consumers are likely to have a higher “marginal propensity to consume” — that is, they are likely to spend, rather than save, a higher percentage of any additional income they have. Thus this type of tax rebate is likely to get a greater bang for the buck than rebates aimed at higher-income consumers.

Research suggests that people will often feel more free to spend, rather than save, this type of “windfall” than they would if the money came as a raise at work. They weren’t counting on the rebate money, and therefore see it as more appropriate to spend.

In the coming months, advertisers will probably come up with numerous “suggestions” as to how consumers should spend this cash. A household with two spouses and two children is potentially eligible to receive two $600 payments and two $300 payments, for a total of $1,800 — enough to buy one or more big-ticket items, like a flat-screen TV or a computer. Alternatively, consumers may spend this money piecemeal, eating out at restaurants more often or buying more small things.

Recently, food prices have increased dramatically. This is due to the cost of production rising with the cost of energy, and agricultural crops increasing in value as many are diverted to alternative fuels. Thanks to rising food and gas prices, an increasing number of low- to middle-income consumers are facing a considerable budget crunch at the end of each month. In the early 2000s, Wal-Mart initially seemed to benefit from the declining economy, as consumers switched many of their purchases to lower-cost outlets. Now, many consumers are having trouble making ends meet, even at lower-priced stores, and as a result many have cut back on their purchases.

The tax rebates may allow many of these consumers to buy things that they wouldn’t otherwise have been able to buy. For such consumers, there won’t necessarily be any big new purchases; rather, the effect will be to counteract the earlier decline in spending.

There will also be some consumers who will actually save their rebate money rather than spending it — some out of fear that they will lose their jobs or opportunities to work overtime in the future. This type of saving limited the effectiveness of a similar stimulus measure employed by Japan, whose economy experienced a significant downturn during many of the last 10 years.

One potential problem with big-ticket purchases is that many electronic products these days are imported from low-wage cost countries such as China. When imported products are sold, the net contribution to the U.S. economy is limited to the “value added” component of distribution in the U.S. In other words, such purchases may increase retail and distribution employment in the U.S., but not manufacturing employment.

The effectiveness of a stimulus measure like the upcoming tax rebate depends partly on the multiplier effect, in which money is re-spent as sellers — and their employees — in turn spend part of their earnings. For example, if consumers increasingly patronize restaurants, restaurant employees will likely work longer hours and receive greater tips, allowing those employees to buy more. And restaurant owners may decide to expand their facilities, in turn creating jobs for people who, in turn, spend their money elsewhere. All of this activity spurs the cycle on to greater heights.

Lars Perner is assistant professor of Clinical Marketing at the USC Marshall School of Business. He is an expert on consumer behavior, online shopping and the psychology of gas price changes.