Tax News: The Response of Household Spending to Changes in Expected Taxes

Although theoretical models of household behavior often emphasize fiscal foresight, empirical studies of household consumption have yet to document the role of news about tax changes. Using novel high-frequency bond data, I develop a model of the term structure of municipal yield spreads as a function of future top income tax rates and a risk premium. Testing the model using the presidential elections of 1992 and 2000 as two quasi-natural experiments shows that financial markets forecast future tax rates remarkably well in both the short and long run. Combining these market-based tax expectations with data from the Consumer Expenditure Survey, I find that spending of high-income households increases by close to 1% in response to news of a 1% increase in expected after-tax lifetime income, consistent with the basic rational-expectations life-cycle consumption theory. These findings imply that by ignoring anticipation effects, previous estimates of the total effect of a tax change could be substantially biased.