How Does Nondurable Consumption Respond To Transitory Income Shocks? Reconciling Natural Experiments and Structural Estimations

Results from natural experiments show that nondurable consumption responds strongly and significantly to transitory variations in income, such as tax rebates or tax refunds, while in estimations of life-cycle models, transitory shocks do not induce significant changes in consumption expenditures. First, I show that life-cycle estimation methods are biased in a standard framework with uncertainty because they implicitly neglect the contribution of precautionary behavior. This biases the results, as the precautionary terms induce a correlation with past shocks that undermines the estimation strategy. Second, I develop a robust estimator that allows for the presence of a correlation with past shocks, and obtain that the elasticity of consumption growth to transitory shocks is statistically significant, in accordance with the literature on tax repayments. The estimation results imply that 12% of a transitory gain in net income is consumed within the following year.