The effect of taxes on debt-financed consumption

An extensive body of tax literature posits that taxpayers respond to changes in tax laws, especially marginal tax rates. The Tax Reform Act of 1986 (TRA 86) reduced marginal tax rates and phased out the tax deduction for personal interest, across time eliminating the tax subsidy on personal interest available to individual taxpayers. This was done in an attempt to encourage savings. Prior research regarding the effects of these changes on debt levels of individuals is limited. As a result, conclusive evidence does not exist regarding the results of the TRA 86 in the area of debt financed consumption. Additionally, up to this point virtually all research in the area has been at a macroeconomic level. This study, through the use of panel data, links the microeconomic behavior of individual taxpayers to previous macroeconomic findings by providing evidence that taxpayers are sensitive to the changes in after tax cost of debt and subsequently on debt financed consumption. The study also finds that lasticities may change over time as well as vary by income level. In a time of increasing consumer debt and decreasing household savings, these findings are likely to have important implications in future policy changes. Lastly, taxpayer elasticity estimates have historically been subject to the methodological choices of the researchers. This study compares several methods of analysis (random coefficient regression, fixed effects model, random intercept model, first difference regression, and difference in difference regression) and provides insight into the relatively better predictor for debt levels of individuals.