Retirement and Economic Behavior

By Henry J. Aaron; Gary Burtless | Go to book overview

Paul N. Courant, Edward M. Gramlich, and John P. Laitner


A Dynamic Microeconomic Estimate of the Life-Cycle Model

The life-cycle model is one of the most commonly used and most difficult to verify in economics. It is widely used to make predictions about the distributional incidence of consumption taxes, the long-term labor supply impact of transfers, and the short-term macro impact of temporary tax cuts. The model is based on the idea that households make decisions about consumption over their entire lifetimes, and in making these decisions take into account the resources they will have available over their entire lifetimes. Thus the model places formidable requirements on households in that it is assumed that consumers can make long-term forecasts of income and wealth with a high degree of confidence. Given that households are able to make such forecasts, the model predicts behavior that often differs quite strikingly from those that assume households behave in a more mechanical or shortsighted manner.

But for all its elegance and rationality, the life-cycle model has not tested out very well. Efforts by macroeconomists to show that temporary tax cuts have very little effect on aggregate demand (as they should in the life-cycle model) are quite inconclusive and ambiguous, even when done with the meticulous care of Modigliani, more than anyone else the father of the model.1

We owe an enormous debt of gratitude to Deborah Laren, who programmed the complex panel data routines used here. We have also benefited from the comments of members of the macroeconomics workshop at the University of Michigan and participants at the Brookings Conference on Retirement and Aging.

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1
See. Franco Modigliani and Charles Steindel, "Is a Tax Rebate an Effective Tool for Stabilization Policy?" Brookings Papers on Economic Activity, 1:1977, pp. 175-209. The important preceding articles are Franco Modigliani and Richard Brumberg, "UtilityAnalysis and the Consumption Function: An Interpretation of Cross-section Data,"

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