Silviase/jgov_v1.4_full_ann huggingface dataset:
Consumer Response to the 1995/1996 Tax Cut: Are Temporary Tax Cuts Effective in Anticipation of Tax Increase?

## Abstract:

This paper tries to evaluate the effects of the 1995/1996 tax cuts administered by the Japanese government. These tax cuts were implemented exactly in the same manner at different timing. Especially, the 1996 tax cut is unique in the timing, i.e. it was implemented only three months before the consumption tax rate increase from 3% to 5%. We use micro-level data of the Family Income and Expenditure Survey (FIES) to evaluate the effect of the 1995 and 1996 tax cuts implemented in December in these two years on individual household's consumption, focusing on the difference between the two episodes. The estimates indicate that these tax cuts actually stimulated consumption on impact, though the effect decreased in following months, and also suggest that the effect was smaller for the 1996 tax cut than the 1995 tax cut. This finding probably suggests that the Ricardian equivalence story might hold and individual households do not respond to a tax cut in anticipation of coming tax increase, when the timing of tax reduction and tax increase is very close.
### 1. Introduction

The continued stagnation of Japanese economy motivated the government to implement a series of tax reductions in the mid 1990s in order to stimulate the economy. At the same time, some of these tax cuts were devised to neutralize the negative impacts of a planned tax increase, that is the consumption tax rate increase from 3% to 5% in April 1997. $ ^{1} $

This paper tries to evaluate the effects of two tax reduction policies implemented in 1995 and 1996, shortly before the tax increase in the spring of 1997. The two tax cuts were implemented exactly in the same manner at different timing. Specifically, the timing of the 1996 tax cut is unique; it was implemented only three months before the consumption tax rate hike. This feature of these two tax cuts motivates us to compare them to see how the effect of tax cuts on consumption implemented in the same way might differ with different intervals to coming tax increase. If consumers anticipate tax increase in near future, those who behave dynamically might not respond to the tax cut. On the contrary, if consumers are myopic or constrained by liquidity, they might increase consumption despite of the anticipated increase in their tax burden. Therefore, how consumers respond to temporary changes in income depends on expectation as well as economic or fiscal conditions. We use the two tax cut episodes in 1995 and 1996 to empirically evaluate the validity of the Ricardian equivalence in this paper.

Although there are little earlier studies on the Japanese tax policy in the 1990s, we have already tackled some of critical issues, using micro-level consumption data. Hori, Hsieh, Murata and Shimizutani (2002) focuses on the 1999 shopping coupon program and Part I and Part II of this discussion paper examine the 1998 tax cut episode as well as the 1994 tax cut. These works on three Japanese episodes in the 1990s demonstrate consistent finding that temporary tax cut stimulated consumption on impact right after it was implemented, with the marginal propensity to consume (MPC) of 0.1 to 0.6, but it declined in subsequent months. This paper (Part III) also deals with temporary tax cuts in Japan, but what is unique about this paper is that it compares the effects of similar tax cuts at different timing, or at different economic and fiscal conditions. The 1996 episode was very close to the expected tax increase in near future (the tax cut was implemented after the announcement of the consumption tax increase), which is not the case for other tax cuts in the 1990s. This unique feature of the 1996 tax cut offers a nice opportunity to evaluate consumers' dynamically optimizing behavior. Like our other three papers, this research takes advantage of utilizing micro-level data of consumers available from the Family Income and Expenditure Survey (henceforth, FIES), monthly consumption data complied by the Japanese government.

This paper is organized as follows. The next section gives a survey of related literature and then Section 3 describes the 1995 and 1996 tax cut policy. Section 4 offers data description and
calculation of tax reduction. Section 5, the main part of this paper, illustrates the strategy to evaluate the 1995 and 1996 tax cut effects on consumption. The last section concludes.

### 2. Literature survey

On tax policies, there are at least two papers that investigate Japanese experiences. Watanabe et. al. (1999) empirically evaluated the effect of Japanese tax cuts after the mid 1970s. Following the methodology by Poterba (1988), they find that the impact of temporary tax reductions is significantly smaller than that of permanent cuts and that 80% of Japanese consumers respond to tax changes at their implementation, not at their announcement. The other quantitative work on Japanese tax cut is Carroll (1999). He uses a simulation based on the habit formation hypothesis. He argues that habits imply an immediate MPC out of permanent shocks of much less one and that “the immediate MPC out of permanent tax cuts may be as low as 30%, suggesting that calls for permanent income tax cut as a quick means of stimulating aggregate demand in Japan may be misguided”.

However, these findings are not fully convincing since they are not based on micro observations. The impact of tax reductions on consumption is likely to be different across households with different characteristics, and it is critically important to take account of heterogeneity of consumers when evaluating the effect of tax policies. As for the U.S., Shapiro and Slemrod (1995) utilize the questionnaire survey to evaluate the effect of the reduction in standard rates of tax withholding on consumption in 1992. They conclude 43% of the sample responded to spend most of the extra take-home pay. However, they perform a similar survey in 2001 and conclude that only 22% of households spent the tax rebates administrated in mid 2001.

Turning to Japan, despite the urgent need for stimulative policies, there are few studies on the Japanese tax cut using micro-level consumption. Hori, Hsieh, Murata and Shimizutani (2002) uses micro data from the FIES to analyze the effect of the Japanese shopping coupon program in 1999 on consumption and concludes that the MPC out of the coupons was 0.3-0.4 in the month when the coupons were distributed, but the MPC falls to 0.1 when the change in consumption is measured over the next 3 or 4 months. Part I and II of this discussion paper also use the same micro data to evaluate the impacts of tax cuts in 1994 and 1998. All of these studies all demonstrate that the effect of tax cuts on consumption are roughly comparable to that of the coupon program, and it declines over the following months.

### 3. The 1995/1996 tax cut

The 1995/1996 tax cuts occupy the last part of the serial tax cut packages implemented in the middle of 1990s. A brief description of the tax cuts in these period would be useful to understand the position of the 1995/1996 tax cut. As detailed below, this paper focuses on the response of worker’s households whose tax payment is withheld at source. In Japan, monthly national tax payment from salary is determined through the “withholding table” that bases on the number of dependants and
taxable income of a household. The local inhabitant’s tax is a fixed amount per month between June (of year t) and May (of year $ t+1 $ ), and the amount is determined by the previous year’s, i.e. year t-1’s, annual income. Both tax payments are withheld by salary payers and thus the amounts are exogenously determined.

The 1994 tax reduction was the first tax cut in the 1990s to stimulate the weak economy after the collapse of the “Bubble economy”. It was also a tax cut in anticipation of a consumption tax rate hike planned in 1997. This tax reduction was thought to be temporary and to end in the following year. The total amount was 5,500 billion yen. Under this tax reduction program, in principle, 20% of total income tax payment between January and June was refunded in June (the upper limit was one million yen) and 20% of income tax amount paid between July and December was refunded in December 1994 $ ^{2} $ . The limit of the tax refunds was two million yen as a whole. At the same time, a tax reduction in the local inhabitants’ tax was also enforced. The inhabitants’ tax payment was exempted in June and July and the due amount after 20% reduction up to the upper limit of 200,000 yen was collected between August 1994 and May 1995.

Although the 1994 tax reduction was planned to be one shot, no sign of economic recovery made the Japanese government continue the tax reduction policy. The 1995 tax reform package was of the same amount (5,500 billion yen) as that of 1994 tax cut, and contained both institutional (permanent) tax cut (3,500 billion yen) and temporary tax cut (2,000 billion yen) $ ^{3} $ . The 1996 tax reduction was implemented exactly in the same manner as that of the 1995 tax reduction. The permanent part of 1995 tax cut was retained even after 1996 and the temporary tax cut was implemented in the same manner in 1996.

Under these reduction programs, the temporary tax cut was implemented in the following way: 15 % of total income tax payment between January and June was refunded in June (the upper limit was 25,000 yen) and 15% of income tax amount paid between July and December was refunded in December. Note that the limitation to be refunded was 50,000 yen as a whole, which was significantly lower than that in 1994 because the part of the temporary tax cuts in 1995 and 1996 occupied 2,000 billion yen while 5,500 billion yen in the 1994 tax cut. In addition, tax reduction in inhabitants' tax (local tax) was also enforced as in 1994. The inhabitants' tax payment was exempted in June only and the due amount after 15% reduction was collected between July and May in the next year. The limit to be refunded was also significantly lowered up to 20,000 yen $ ^{4} $ .
### 4. Data Description and Tax Cut Calculation

The data used in this study is the micro-level data from the Family Income and Expenditure Survey (FIES), conducted by the Ministry of Public Management, Home Affairs, Posts and Telecommunications. $ ^{5} $ The survey covers approximately 8,000 households, which are representative at the national level. Approximately, 1,300-1,400 households enter the sample and the comparable size of households gets out of the sample. This study uses only worker’s household information, which occupies more than half of the sample, because monthly information on receipts is only available for workers’ households and the monthly pattern of income for workers’ households is very different than that of other households due to the bonus system.

Each household is surveyed for six months and one–sixth of the households are replaced by new households every month, making it possible to construct six-month panels. In order to improve the reliability of our estimates, a household is excluded if (1) the reported age of the household head decreases or increases by more than one year during 6 months or; (2) the household's tenancy status changes from owner to renter or the reverse, because these changes are likely to be due to large shocks that may also have large effects on the household's consumption. $ ^{6} $ Moreover, a household is excluded if the number of family members is greater than 10 because consumption of such large households is different from that of smaller households $ ^{7} $ .

The national income tax cut amounts for individual households in the case of the 1995 and 1996 tax cut implemented in December are calculated as follows.

(A1) Tax cut amount= Tax12*-Tax12=0.15*(Tax7+Tax8+Tax9+Tax10+Tax11+Tax12*) where Tax7-Tax12 are tax payment in each month between July and December and Tax12* is tax payment in December without tax reduction, which is not available in the FIES. Rearranging (A1), the following relation is obtained.

(A2) Tax cut amount = $ (0.15 \times (\text{Tax} + \text{Tax8} + \text{Tax9} + \text{Tax10} + \text{Tax11}) + \text{Tax12})/0.85 - \text{Tax12} $

where all variables in the right hand side are available. If the calculated tax cut amount is greater than 25,000 yen, it sets to be 25,000 yen. Since the amount of the inhabitant tax cut in each month is same and small between July and May in the next year, this paper ignores the effect of the inhabitant tax cut.

In what follows, we will use the panels of August to January and September to February to evaluate the effect of the 1995/1996 tax cut. These panels are necessary to evaluate the effect totally because previous studies demonstrate that the effect of tax cut on consumption on impact was substituted in later months. The panels beginning after October are not used in this paper because consumption increased substantially in March 1997, just before the implementation of the
consumption tax increase. Since national tax cut amounts are based on the total tax payment between July and December, the panels beginning in August or September lacks data on tax payment in July and/or August. We calculated tax payments in these months as the average of tax payment in months without bonus payment.

Moreover, we disaggregate the different items into four consumption categories: durables, semi-durables, non-durables, and services. The summary statistics of the panels used in this paper can be seen in Table 1.

### 5. Impact of the 1995/1996 Tax Cut on Consumption

We begin with using the six-month panels from the FIES to estimate whether consumption changes when consumer receives tax cut benefit. We will compare households to see whether families with a larger tax cut amount increase their consumption by more than families with a smaller tax cut amount, controlling for the cross-sectional differences between similar families in other years.

The basic empirical specification employed is the following linear Euler equation:

$$ \begin{aligned}(1)\ \ln\left(\frac{C_{h,t+1}}{C_{h,t}}\right)=&\sum_{n=0}^{2}\ a_{1n}\cdot\left(\frac{Taxcut_{h,t+1-n}}{MonthlyIncome_{h,\tau-1}}\right)+\sum_{n=0}^{2}\ a_{2n}\cdot\left(\frac{Taxcut_{h,t+1-n}}{MonthlyIncome_{h,\tau-1}}\right)*1996DUM\\&+Z_{h,t}^{^{\prime}}\cdot a_{3}+Month^{^{\prime}}\cdot a_{4}+\varepsilon_{t+1}\end{aligned} $$

where h indexes households and t refers to the month. The dependent variable is the log of the ratio of monthly consumption in household h in month t. The main independent variables are $ \frac{TaxcutN_{h,t+1-n}}{Monthly Income_{h}} $ , which is the value of national income tax cuts in December received by a household relative to the household's monthly income $ ^{8} $ . Moreover, the specification includes the interaction term between the main independent variable and a dummy variable for 1996 to address the possibility that the impacts on consumption might be different between 1995 and 1996. We allow lags of both main independent variables to address the possibility that a household does not spend the tax cut immediately. The monthly value of tax cut is exogenously determined as documented in the previous section. The main independent variables are of course set to zero for other control years. $ Z_{h,t} $ is a vector of household characteristics (a quadratic in the age of the household head, the number of family members and change in the number of family members). Month t is a vector of dummy variables for each month in each year. The coefficients of our interests are $ a_{10} - a_{12} $ and $ a_{20} - a_{22} $ , which measure the elasticity of consumption to income variation due to the tax cuts. We excluded observations if the absolute change in monthly consumption exceeds the mean by more than three standard deviations.

As long as the main independent variables are orthogonal to other income shocks, the
estimated $ a_{10} - a_{12} $ and $ a_{20} - a_{22} $ are not affected. In order to detect whether omission of other income shocks as independent variables affects the coefficient estimates, we also tried the following specification.

$$ \begin{aligned}(2)\quad&\ln\left(\frac{C_{h,t+1}}{C_{h,t}}\right)=\sum_{n=0}^{2}a_{1n}\cdot\left(\frac{Taxcut_{h,t+1-n}}{MonthlyIncome_{h,\tau-1}}\right)+\sum_{n=0}^{2}a_{2n}\cdot\left(\frac{Taxcut_{h,t+1-n}}{MonthlyIncome_{h,\tau-1}}\right)*1996DUM\\&+\sum_{n=0}^{3}a_{3n}\cdot\left(\frac{Bonus_{h,t+1}}{MonthlyIncome_{h,\tau-1}}\right)+\sum_{n=0}^{3}a_{4n}\cdot\left(\frac{OtherIncome_{h,t+1}}{MonthlyIncome_{h,\tau-1}}\right)+Z_{h,t}^{\prime}\cdot a_{5}+Month_{t}^{\prime}\cdot a_{6}+\varepsilon_{t+1}\end{aligned} $$

where $ \frac{Bonus_{h,t+1}}{Monthly Income_{h}} $ is the value of bonus received by a household relative to the household's monthly income. A household typically receives bonus in December in Japan. Moreover, $ \frac{OtherIncome_{h,t+1}}{Monthly Income_{h}} $ , which is total monthly receipt except tax cut and bonus relative to monthly

income and its lags in order to control for delayed responses. $ ^{9} $

We use specification (1) and (2) to evaluate the 1995/1996 tax cut as discussed above. We use the sample between 1990 and 1993 as the control years to confirm whether some specific shocks in 1995 or 1996 are driving the results $ ^{10} $ .

Table 2 demonstrates the results on total consumption based on the specification (1) and (2). Except Column (2), the coefficients on the contemporaneous tax cut are positive and significant, followed by negative coefficients on one-month lag terms. To take an example of the results of Column (1), the MPC on impact is estimated to be 0.7-0.8 but it declines over months. Note that the interaction term between the current tax cut and dummy variable for the 1996 sample are large and negative, though they are not statistically significant, which implies that the effect of tax cut was smaller in 1996 than in 1995, despite the fact that the tax reduction was implemented in the same manner. This suggests the possibility that consumers are less excessively sensitive to change in income at the timing close to future tax increase.

A closer examination of more disaggregated type of consumption shows the same pattern. The results reported in Table 3-1 and 3-2 suggest that the 1995/1996 tax cut stimulated consumption on impact but it was followed by a negative coefficient on one month lag, and most of the interaction terms between the current tax cut and dummy variable for the 1996 sample are large and negative. Some coefficients on the interaction terms between one month lagged tax cut term and the 1996 dummy are positive but the sum of these coefficients is zero or negative $ ^{11} $ .
In order to examine the impact of liquidity constraints, we examine the effect of the 1995/1996 tax cut by income levels. We use the panel from September to February to cover the period after the implementation as long as possible. We divide the sample by the average of annual pre-tax income in the previous year. The results reported in Table 4-1 and 4-2 indicate that the coefficients are larger for households with lower income, which are likely to be liquidity constraint. At the same time, these households have large and negative coefficients for the interaction term between the current tax cut and the 1996 dummy. This means that households under liquidity constraint were less sensitive to temporary change in income in anticipation of tax increase in near future.

These findings are consistent with past research on Japanese tax cuts in the 1990s. Hori, Hsieh, Murata and Shimizutani (2002) demonstrate that the 1999 shopping coupon program stimulated consumption of semi-durables with the MPC of 0.3-0.4 in the first month but the MPC falls to 0.1 over the next 3 or 4 months. Shimizutani (2002) evaluates the 1998 tax cut stimulated consumption of services with the comparable MPC and it was substituted in the subsequent months and it is also true for the 1994 tax cut though the estimated MPC is smaller to be 0.1-0.2.

### 6. Conclusion

This paper explores the consumer reaction to the 1995/1996 tax cuts. These tax cuts were implemented in the same way but at different timing, and thus this study emphasizes the difference of these tax cuts on consumption. Especially, the 1996 tax cut is unique in the timing; only three months before the increase in consumption tax rate from 3% to 5%. Using micro-level data of the Family Income and Expenditure Survey (FIES), the estimates demonstrate that these tax cuts actually stimulated consumption on impact, though the effect decreased in following months, and also suggest that the effect was smaller for the 1996 tax cut than the 1995 tax cut. This finding weakly suggests the possibility that the Ricardian equivalence story might hold when the timing of tax cut and tax increase is very close and individual households did not respond to a temporary tax cut in anticipation of tax increase undertaken shortly after.

There are two directions for fruitful further research. One is to evaluate the effect of permanent tax cut on consumption, which was implemented in 1995 and 1999. Especially, a comparison of consumption effect between the institutional tax cuts and temporary tax cuts implemented in 1995 would be interesting. An empirical investigation on the effect of permanent tax cut compared with temporary tax cut will bring substantial implication for both policy-makers and academic researchers. The other is to explore the “non-Keynesian effect” using micro-level data. There have been several studies on the non-Keynesian effect using international cross-sectional data and some of them did find the effect in Denmark or Sweden. However, to our best knowledge, there is not research to tackle the topic using household-level data. The finding in this paper implies that
Ricardian equivalence story might have held shortly before tax increase and dynamic behavior of consumers should be investigated more deeply to bring several important policy implications for macro policy makers.