Tax Liabilities and Spending

Readers Question: Why might the public ignore future tax liabilities when making spending decisions?

A tax liability is a tax bill that you will have to pay the government in the future.

In theory, if you have a large tax liability in the future, you will reduce current consumption to be able to pay the tax liability when payment is due. However, consumers may not do this for various reasons.

Poor Information. Consumers may be unware or forget about the future tax liability. They may even know they have to pay it but be reluctant to change spending in the short term because they push it to the back of their mind or don’t want to take part in long term spending.

• Generally economic theory assumes consumers are rational, but, in practise this is often not the case.

Borrowing. Consumers may prefer to maintain current spending and then borrow for future tax liability through credit cards or a loan.. This might be more difficult in current credit crunch, but in past at least, borrowing has been relatively easy.

Autonomous consumption. A large part of consumer spending is automatic – mortgage payments, bills, food all these consumer spending is seen as indispensable so consumers are reluctant to reduce spending. Of course, this doesn’t explain why consumers may continue to buy inessential goods.

Other ideas to consider:

Life Cycle Hypothesis. This is the theory that consumers seek to smooth consumption over their life. For example, borrowing when a student, saving during periods of work and then running down saving in retirement. In theory, this life cycle hypothesis could be extended to an annual budget of spending.