Windfall Income and Consumption

Author(s): Ronald Bodkin

Source: The American Economic Review , Sep., 1959, Vol. 49, No. 4 (Sep., 1959), pp. 602-
614
Published by: American Economic Association

Stable URL: https://www.jstor.org/stable/1812914

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 WINDFALL INCOME AND CONSUMPTION

BY RONALD BODKIN*

In this paper the reaction of consumer units to a temporary income

change is explored. The data are used to test a critical strand of Milton
Friedman's permanent income hypothesis, though the results are inter-
esting by themselves. In the concluding section, an implication of the
analysis for tax policy is also discussed.

I. The Permanent Income Hypothesis and the Proposed Test

Friedman, in a recent monograph [2], has set forth a theoretical
explanation of consumption behavior. Under his permanent income
hypothesis, both actual consumption and actual income are broken
up, at least conceptually, into permanent and transitory components.
The permanent component of income is that portion of an individual
unit's income that the unit regards, consciously or behaviorally,' as
permanent. The transitory component, which may be either positive
or negative, is that part of income produced by influences that the
individual unit regards as random. Permanent and transitory com-
ponents of consumption are distinguished analogously. It is assumed
that the permanent component of income is uncorrelated with its
* The author, who is a graduate student at the University of Pennsylvania, is indebted
to Irwin Friend and Lawrence Klein for many useful suggestions. John DeCani and Robert
Jones aided with the computational work. The helpful comments of James Ball and Edwin
Kuh are also acknowledged.
This article is based on research undertaken in connection with a broad study of con-
sumer expenditures, incomes and savings at the Wharton School of Finance and Commerce,
University of Pennsylvania. The study, which is financed by a grant from the Ford
Foundation, is based largely on the 1950 survey of the Bureau of Labor Statistics of 12,500
families in 91 representative cities. The principal purpose of this survey was the revision
of expenditure weights in the Consumer Price Index. 1500 items of budget information
have been tabulated in 18 volumes of statistical tables. The data are believed to be more
reliable for middle-income than for the very lowest and the very highest, and for wages
and salaries than for other types of income. In any statistical investigation, there are sam-
pling, reporting, and processing errors. Hence analytical results, parameter estimates, and
derived relationships must be interpreted cautiously. For more complete description and
evaluation of the survey, see [17 ].
' The definition on a behavioral basis would appear to be a better definition in the real
(uncertain) world. This would appear to be Friedman's view, as he asserts several times
that the permanent component of income cannot be measured for the individual unit.

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 BODKIN: WINDFALL INCOME AND CONSUMPTION 603

transitory component; this is principally a definitional postulate. A

similar relationship is assumed to hold between permanent consumption
and transitory consumption. Friedman asserts, on the basis of theoreti-
cal considerations, that permanent consumption is a constant function
of the level of permanent income. This is the first major substantive
conclusion of the hypothesis. (The constant connecting permanent
consumption, cp, with permanent income, yp, depends upon several
variables-the interest rate, i, the ratio of nonhuman wealth to total
wealth, w, and the portmanteau taste variable, u-but it does not
depend, in this model, on the level of permanent income.2
Friedman further postulates that transitory income and transitory
consumption are uncorrelated. This is a crucial postulate, for it implies
that transitory income does not give rise to consumption (of either
type) on a systematic basis. Transitory income cannot give rise to
transitory consumption, for the two are uncorrelated, nor to perma-
nent consumption, for transitory income and permanent income (and
hence transitory income and permanent income's constant multiple,
permanent consumption) are uncorrelated. Hence consumption and
transitory income are uncorrelated. The empirical evidence to be
presented is directed toward this proposition.3
One point should be made clear. Consumption, according to this
model, is defined as the value of services enjoyed by the unit during
the period under consideration. Thus consumption becomes expendi-
ture on nondurable goods plus the rental of the services of durable
goods. In the customary one-year accounting period, purchases of
durable goods would be mainly saving, not consumption, since only
a small part of the services rendered by a durable good during its
lifetime is consumed during the year. Thus expenditures on both
durable and nondurable goods would give too high an estimate for a
unit's consumption, as they would contain an element of saving. There
is always an offset to this bias, because of services rendered by durable
goods purchased in previous time periods. Still, during years when
stocks of consumer durables are rising, as Friedman points out, the
conventional definition of consumption expenditures overstates con-
sumptionas defined for his theory.
2 In equation form, we have:
(1) cp= kyp, where k=k(i, w, u).
'The first conclusion (that permanent consumption is a constant function of the level
of permanent income) has already been subjected to a number of empirical tests. See [1],
[3], [4] and [6]. In general, the evidence presented in these papers does not constitute strong
support for the first substantive conclusion of the permanent income hypothesis. The second
conclusion (that transitory income and consumption are uncorrelated) has been subjected
to far fewer tests. The paper by Klein and Liviatan [51 is the best previous test of this
second substantive conclusion of which I am aware.

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604 THE AMERICAN ECONOMIC REVIEW

In their paper [5], Klein and Liviatan used the 1953 and 1954
Savings Survey data for Great Britain to compute regressions of the
savings-income ratio against several explanatory variables. One of
these was WIY, the proportion of total income received in the f
of "windfall income." Windfall income consisted of life insurance
benefits, gambling winnings, cash gifts, cash legacies, postwar credits,
and other lump-sum transfers of money. The results are rather inter-
esting. For retired and unoccupied units, the implied marginal pro-
pensity to consume out of windfall income is .92; for lower-income
employees, this figure is .65; and for upper-income employees it is
.74. If windfall income were defined in these regressions in the same
way as in the permanent income hypothesis, this would constitute
evidence tending to discredit this strand of the hypothesis.
In point of -fact, no strong identification between these two concepts
can be made. Friedman's definition of transitory income is income
which is viewed by the recipient unit as the result of chance or acci-
dental factors. Now life insurance benefits would not fall into this cate-
gory. Similarly, there is every reason to expect that the expert gambler
considers his gambling winnings "permanent income"; he is likely to
count on these as a supplementary source of income. Heirs also have
been known to anticipate or count on legacies. To the extent that this
is the case, the legacies would not represent windfall income but would
represent a final transfer of an asset that was a contingent asset for
many years. Thus the results of this study, while suggestive, do not
constitute evidence seriously damaging to the perrmanent income hy-
pothesis.
We now seek to find a stronger test of the result that consumption
and transitory income are uncorrelated. In November 1949 the Bureau
of the Budget announced that National Service Life Insurance divi-
dends would be paid out, in fiscal 1950, to veterans of the second
world war who had held military insurance. Payments began January
16, 1950; three-quarters of the dividends had been paid out by the
end of March. These dividends amounted to $2.8 billions; the average
payment per veteran was $175 [8]. The payments were presumably
made possible by more favorable mortality experience than had been
allowed for in setting the premium levels. They would represent, from
the point of view of the permanent income hypothesis, transitory in-
come: before the dividend was announced, the dividend recipients
had no inkling that such a payment would be made. The dividend
payment represented a cost saving on an item of consumption (life
insurance) for which an individual consumer would have believed
that he had been charged adequately. Because of the short time-
lag between the public announcement and the payment, there is no

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 BODKIN: WINDFALL INCOME AND CONSUMPTION 605

reason to believe that this income was anticipated in prior years.4

The goal is to isolate the influence of this factor on the consumption
behavior of the units fortunate enough to receive this additional source
of revenue. In the 1950 Bureau of Labor Statistics Survey of Consumer
Expenditures, data on individual household units showing the size of
income primarily from this source alone have been collected. By com-
puting multiple regressions, we can attempt to isolate the influence
of these dividend payments5 on the consumption of units receiving this
windfall. In particular, we can compare the results obtained with the
prediction that the permanent income hypothesis gives and with the
prediction that another explanation of consumption behavior, an
absolute income hypothesis, would give. The prediction on the basis
of an absolute income hypothesis is relatively simple. From the work
of various researchers in this field, we might expect that the marginal
propensity to consume out of windfall income would lie between .6
and .9, if windfall income is substantially the same as regular income
in its effect on consumption behavior.
On the other hand, a prediction based on the permanent income
hypothesis is somewhat more difficult. In his book [2, p. 215] Friedman
appears to agree that this dividend payment constitutes a definite test
of the permanent income hypothesis. In discussing this test, Friedman
argues that the regression coefficient (the marginal propensity to con-
sume out of this transitory income) should be "small, about .3 or so."
He arrives at this theoretical prediction in the following manner.
From empirical data, Friedman estimates that the time horizon of the
individual household units, in the real (uncertain) world, is approxi-
mately three years. Because of this, approximately one-third of the
windfall will enter the unit's permanent income stream. Thus, aver-
age propensity to consume out of permanent income (which has
been found to be roughly .9) multiplied by one-third the dividend
4 Suppose the windfall receipt was anticipated at a prior point in time. At what point
of time does this unusual source of income become permanent income? Friedman is not
too clear on this point, but it would appear that he assumes that on a behavioral basis the
unusual income receipt becomes permanent income only at the time of payment. Thus his
theory would predict a normal marginal propensity to consume out of that portion of the
unusual receipt that is deemed permanent income (typically one-third) in this case. On
the other hand, if the unusual receipt becomes permanent income at the time when the
recipient learns about it, then the results may be different. For then consumption expendi-
tures might be expected to increase in time periods prior to the actual payment, in anticipa-
tion of this unusual receipt. But, in the period of payment itself, consumption expenditures
might be expected to be not much above normal, as the unusual income receipt would prob-
ably be used to pay off debts or to replenish savings which the unit had, as it were, bor-
rowed from itself. Hence the theory of consumption behavior under review might appear
to predict in this case that for the period of payment, the unusual receipt would be, on the
average, largely saved.
'These dividend payments were not uniform; some units received larger payments than
others.

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606 THE AMERICAN ECONOMIC REVIEW

income will give an estimated MPC out of dividend income of .3.'

The permanent income hypothesis does, however, allow for a wealth
effect, which becomes appreciable if the windfall is large enough. Thus
the ratio (w) of nonhuman wealth to total wealth (which may be
interpreted as the ratio of nonhuman wealth to permanent income)
may be increased, effecting a reduction in the urgency to save to pro-
vide a reserve against contingencies. Hence a higher average pro-
pensity to consume out of permanent income may result. However,
the average value in the sample for dividend income received was
approximately $250, an amount relatively small in terms of either
permanent income or nonhuman wealth. Hence the wealth effect will
be, in all likelihood, small, and only minor reservations are engendered
by this possible complication.

II. Results of the Present Investigation

A subsample of 1414 dividend recipients was selected. This sub-
sample included only 2-4 person families, where the age of the head
of the family was between 21 and 45, and it excluded entrepreneurs
and the unemployed. This is a group whose consumption behavior,
from the point of view of the permanent income hypothesis, should
be relatively homogeneous. Exclusions were made on no other basis.
Twin regressions were computed: for the first regression, consumption
was defined to include expenditure on consumer durables. As mentioned
earlier, this is probably too large a measure of consumption, as defined
in the permanent income hypothesis, when the stock of consumer
durables is increasing! For the second regression, consumption was
defined to exclude expenditure on consumer durables. This is too small
a measure of consumption as defined in the permanent income hy-
pothesis. Nevertheless, if we are willing to postulate continuity in our
'Irwin Friend has raised the question whether a different value of the MPC out of wind-
fall income is theoretically more appropriate. The dividends were received in a single lump
payment, and the recipient had no basis to expect that this source of income would ever
be repeated. Consequently it seems a bit arbitrary to say that one-third of the dividend
receipt entered the permanent income stream for the year in question, owing to the haziness
of the future and the shortness of households' time horizon. A strict interpretation of the
permanent income hypothesis might entail considering all of the dividend receipt as transi-
tory income; in this case, the predicted marginal propensity to consume out of this wind-
fall would be close to zero, with only random variation about this average figure. However,
since Friedman's hypothesis was under consideration, Friedman's theoretical prediction was
used as the basis for performing the test. It is worth observing that the two hypotheses
offer widely differing values of the MPC in question (.3 as an upper limit for the perma-
nent income hypothesis contrasted with .6 as a lower limit for an absolute income hy-
pothesis).
'This assumption may break down for particular subclasses. Although the stock of con-
sumer durables may be increasing for the group as a whole, there is no logical reason why
it should be increasing for every subclass within the group. The error introduced is, however,
likely to be small. Consequently the discussion will be based on the postulate in the text.

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 BODKIN: WVINDFALL INCOME AND CONSUMPTION 607

data, then we have a solution. Suppose both measures of consumption

lead to the same conclusions. Then we can assert that the intermediate
measure of consumption, giving intermediate results, will also lead to
the same conclusions.
The following regression was obtained for the 1414 families in our
sample:
(2) c = $964 + .747y + .966d S, = $968
(76) (.017) (.145) R= .601

For this equation, c is total family consumption including expenditure

on durable goods, y is family income after taxes and not including the d
variable, and d is bonuses, mustering-out pay, war insurance refunds,
and military unemployment insurance.8
The bulk of the d variable is the National Service Life Insurance
dividend payments. The average value of the d variable in the sample
was $255; the average value of the dividend payments in the universe
was approximately $175. One possible explanation of this discrepancy,
which is much too large to be attributed to sampling variability alone,
is the method of selection of the subsample. Thus the size of the divi-
dend payment to any individual was primarily an actuarial matter. It is
quite likely that married dividend recipients carried greater amounts of
insurance (or had them in force for a longer period of time) than single
veterans. Hence there may have been a larger payment, on the average,
to members of the subsample group than to single veterans. For this rea-
son, one might expect to find a larger average dividend payment in the
selected subsample. Furthermore, the data in the sample are on a house-
hold basis, while the universe average is a per-person figure. Hence the
possibility that there might be more than one veteran per household,
raising the sample average, exists. Of course, other miscellaneous items
of military income included in the d variable may also be contributing to
increase the sample average. In any case, these considerations suggest
that the greater part of the d variable is the dividend payments previ-
ously discussed.
The average values in the sample of c and y are $4087 and $3853, re-
spectively. The partial correlation coefficient between total family con-
sumption and dividend income, holding the influence of family income
net of taxes and net of dividend income constant, is .174. As this is 6
times its own standard error, this measure is statistically significant.
It would appear that dividend income has a noticeable effect on families'

'S. is the estimated standard deviation of the residuals, while R' is the coefficient of
determination and may be interpreted as the fraction of "explained" variance of c. The
numbers in parentheses are standard errors of the respective parameter estimates. All the
parameters are at least 6 times their respective standard errors and hence are statistically
significant.

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608 TIHE AMERICAN ECONOMIC REVIEW

consumption behavior. In particular, the best point estimate of the mar-

ginal propensity to consume (including expenditure on durables) out
of windfall income is .97, with a standard error of .15.
This result, however, is not necessarily inconsistent with the per-
manent income hypothesis. It is possible that the greater part of these
consumption expenditures were purchases of consumer durables. In this
case, the greater part of these purchases out of w-indfall dividend income
would be saving, as defined for this hypothesis. Furthermore, the small
fraction of these purchases which could be considered as immediate con-
sumption might give a value which would fall in the 0-.3 range suggested
earlier as hypothetical values of the MPC predicted by the permanent
income hypothesis.
For this reason, we are interested in the results obtained when con-
sumption expenditures are netted of expenditures on durable goods.
denotes total family consumption not including purchases of durable
goods. The average value of c' in the sample was $3301, and the following
regression was obtained for the 1414 families in the selected subsample:
(3) c' = $959 + .560y + .723d S= $725

(57) (.012) (.109) R2 = .601.

Thus, the best point estimate of the marginal propensity to consume

nondurables out of this windfall income is .72.9 The best point estimate
of the marginal propensity to consume out of this windfall income,
where consumption is defined exactly in terms of the permanent income
model, would be some number intermediate between .72 and .97. It
would be reasonable to expect that the true universe value of this param-
eter would lie in this range also. But in any case, the best point estimate
of this marginal propensity to consume, consumption being defined pre-
cisely in terms of the permanent income model, is much higher than .3,
the result predicted by the permanent income hypothesis. If we make
use of the estimated standard errors of the regression coefficients, this
discrepancy appears to be highly significant statistically.'0 Flurthermore,
'For this regression also the sample parameters are 7 or more times their respective
standard errors. Hence they are statistically significant. Once again, the partial correlation
coefficient between c' and d, holding the influence of y constant, is .174 and is approximately
six times its own standard error. Hence it can be considered statistically significant.
Suppose we wish to test whether the (unknown) sample estimate of the theoretically
correct MPC differs from its theoretically predicted value, .3, by more than can be reason-
ably attributed to sampling variability. Now this theoretically correct MPC would prob-
ably lie closer to the marginal propensity to consume nondurables, as most of the pur-
chases of durable goods for a particular year would be savings, according to this model.
Hence, for the sample value of the theoretically correct MPC, assume a value .75, which
is close to the sample value of the marginal propensity to consume nondurables. As the
estimated standard error of this sample parameter, choose .15, the larger of the two esti-
mated standard errors of the sample regression coefficients. Thus .75 is the estimate from
the sample of the marginal propensity to consume out of windfall income, when consump-

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 BODKIN: WINDFALL INCOME AND CONSUMPTION 609

an absolute income hypothesis has no difficulty in explain

served results; .72 and even .97 are plausible values for marginal
propensities to consume. It would appear that an absolute income hy-
pothesis serves as a superior explanation for this body of data.

III. Possible Reservations

It might be argued that these results are peculiar to 1950; the in-
fluence of scare buying due to the onset of the Korean war stands out as
an obvious factor. In terms of the permanent income hypothesis, there
may have been a positive mean component of transitory consumption.
But these influences, if important, should have made their effects felt on
the constant term in these regressions and on the coefficient of regular in-
come (the marginal propensity to consume out of y). It does not appear
that even these unusual influences suffice to explain the differentially
higher spending of those who received greater amounts of dividend in-
come. On the other hand, one can never infer very much from a single
sample at one point of time. Since this was an unusual period, due cau-
tion in asserting that these results are of general applicability is ad-
visable.
It also might be asserted that these results are peculiar to the particu-
lar sample. Often there is nothing that the investigator can do about this
possible source of error, since even random sampling can produce a
most unrepresentative sample in particular cases. However, there is
something that can be done here. We can compare the regression results
of this subsample with those of a second subsample of family units
which did not receive war insurance dividend payments. This second
subsample is also drawn from the BLS survey of consumer expenditures
for 1950. Like the first subsample, it includes 2-4 person family units,
in which the age of the head is from 21 to 45, and it excludes entre-
preneurs and unemployed.
The second subsample contained a relatively large number of extreme
cases, with incomes either above $10,000 or below $1000. It thus turned
out that, for this group, the regression containing all incomes classes
did not accurately represent consumption behavior in the central ranges
of disposable income. Hence regressions of consumption on income for
after-tax incomes from $1000 to $10,000 were computed. For purposes
of comparability, regressions of consumption on income (net of the d
variable) and on war insurance dividend income were also computed
for the same income classes of the first subsample (the veterans).
tion is accurately defined from the standpoint of the pernanent income model. .3 is the
theoretical value of this parameter. The difference between .75 and .3 is .45, which is three
times .15. A discrepancy as large or larger would be observed as the result of chance forces
only 3 times in a thousand. The values chosen above are conservative and tend, if they give
rise to any bias, to understate the level of statistical significance.

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610 THE AMERICAN ECONOMIC REVIEW

For the second subsample (the nonveterans), for income classe

$1000-$10,000, we have:
(4) c = S1091 + .757y,

(5) c' = $1014 + .583y.

For the first subsample (the veterans), for income classes $1000-
$10,000, we have:
(6) c = $858 + .774y + .968d,

( 7)c' = $902 + .5 76Y + .70d;

c, c', y, and d are defined as they were previously.

The difference in the intercepts (whether we are comparing the first

or second set of regressions) reflects possibly the higher mean income
in the nonveteran subsample and/or the larger average family size of
this group.11 Nevertheless, both the marginal propensity to consume
(including expenditure on durables) out of regular income and mar-
ginal propensity to consume (excluding expenditure on durables) out of
regular income do not differ significantly between the two samples. (This
statement is made on the basis of the estimated standard errors.) Hence
it would appear that the results discussed above are not, in all likeli-
hood, the result of an atypical sample.
There is a possibility that these results may be due to the special
character of the dividend recipients selected in the first subsample. On
the whole, the dividend recipients are a relatively young group (even
when compared with the nonveteran group); they are drawn from a
stratum of the population known to have a high propensity to consume.
Hence it might be argued that these results might not be applicable to
other elements of the population. In terms of the permanent income hy-
pothesis, they might represent a group with a high permanent income
relative to current or measured income. This group might not be con-
suming at levels warranted by their levels of permanent income, since it
is rather difficult to borrow (after a certain point) against higher in-
come expected in the future. Consequently a receipt of this kind might
temporarily release the members of this group from the year-to-year
budget restrictions on their consumption. Thus the windfall might be
responsible for the increased consumption of this group only in so far
as it allowed the recipient units to spend up to their permanent income.
But if this were the case, then these results might not carry over to
other groups in the population. These possible strictures constitute
another reason why the relations and parameter estimates discussed
above must be interpreted with due caution.
' It may merely reflect sampling variability. The standard error of the constant terms
in equations (4) and (5) is approximately $100. Hence the discrepancy between the con-
stant terms of equations (5) and (7) does not appear to be statistically significant.

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 BODKIN: WINDFALL INCOME AND CONSUMPTION 611

One final and perhaps most serious reservation remains to be dis-

cussed. In commenting on an earlier version of this paper72 Friedman
raised the question whether the regression coefficients of the d variable
(the estimated MPC's out of dividend income) might be, in some sense,
spurious. There is the possibility that the d variable could display a
covariation with indicators of permanent income, such as age, educa-
tion, or family size. (This seems plausible when one recalls that the
size of dividend payments to individual recipients was dictated by
actuarial considerations and hence depended primarily on the size of
the policy and the length of time the policy was in force. Thus it is quite
likely that (for example) older individuals-those with higher perma-
nent incomes, ceteris paribus, in the theory under review-received
higher dividend payments.) If the d variable were correlated with indi-
cators of permanent income, the regression coefficient of the d variable
might be expected to be high. In the permanent income interpretation,
this result might occur, not because dividend income systematically gives
rise to consumption but because we had unwittingly classified the units
studied by a variable that serves as a proxy for permanent income. The
causality would then be reversed-the units would not display relatively
high consumption because they had relatively high dividend income; in-
stead, they would have high consumption and high dividend income pre-
cisely because they had high permanent income.
Nevertheless, matters are not so serious as might first appear. The
y variable is of course not the same thing as permanent income but it is
highly correlated with it. Therefore, it might also be strongly correlated
with the indicators of permanent income. Since the regressions of con-
sumption (according to the two definitions) were run against both regu-
lar income and dividend income, establishing the existence of a correla-
tion between the d variable and an indicator of permanent income
is insufficient to establish a bias in the estimate of the MPC out of
dividend income. Only the existence of a correlation between d and an
indicator of permanent income, after the influence of measured income
has been eliminated, i.e., the existence of a positive partial correlation
coefficient, will suffice to establish a bias, as Friedman points out. If, for
example, there is a positive correlation between dividend income and
age and a correlation of greater magnitude between regular income and
age, the partial correlation coefficient between age and dividend income
could be small and the extent of the bias negligible. All of this discussion,
however, merely constitutes conjecture. The appropriate manner of re-

12 Milton Friedman's comments on an earlier draft of this paper were made at the Con-
ference on Consumption and Saving, held at the University of Pennsylvania, March 30-31,
1959. Friedman of course bears no responsibility for anything which appears in this para-
graph or the one immediately following, although I have attempted to represent his position
accurately.

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612 THE AMERICAN ECONOMIC REVIEW

solving this difficulty is to compute the regression of consumption (de-

fined in both ways) against regular income, dividend income, and sev-
eral indicators of permanent income. This will be done and the results
presented at a later date. If the regression coefficient were to decrease
(and decrease sufficiently), this would constitute evidence favorable to
this strand of the hypothesis. Still, granting that regular income is by
itself a rather good proxy for permanent income, one might not expect
the introduction of additional variables into the multiple regressions to
yield substantially lower estimates of the MPC out of dividend in-
come.'3
One possible indicator of permanent income is the age of the house-
hold head; for the group studied, it is safe to assume that permanent in-
come increases, on the average, with this variable. Accordingly, age of
the household head, A, was introduced into the previously employed
regression equations. The following results were obtained for the 1414
members of the veterans subsample:

(8) c =z$990 + .747y + .968d-.944A

(156) (.017) (.145) (4.97)
R 2 .601, Sit $968,

(9) c' - $610 + .550y + .707d - 12.7A

(116) (.013) (.108) (3.7)
R = .604
St, $722.

A comparison of equation (8) with equation (2) and equation (9) with
equation (3) suggests that the regression coefficients of d (the estimated
marginal propensities to consume out of windfall dividend income) are
virtually unaffected. Hence it is not likely that dividend income received
by an individual is serving as a proxy for that individual's permanent
income status. Other indicators of permanent income ought to (and will)
be tried, however, before this conclusion can be definitely accepted.
It is interesting to compare the marginal propensities to consume out
of the windfall dividend income with the marginal propensities to con-
sume out of regular income. (The possibility of bias in the estimates
"In his discussion, Friedm-an suggested that the best point estimate, from the data, of
the marginal propensity to consume nondurables out of dividend income would be .48,
after performing calculations designed to eliminate the possible bias discussed in the text.
(Performing a similar set of computations lowers the estimate of the marginal propensity
to consume both nondurables and durables out of windfall income from .97 to .85.) It
should be pointed out that .48 is still much closer to .56 (the estimated marginal pro-
pensity to consume nondurables out of regular income) than it is to .30 (the hypothetical
value predicted by the permanent income hypothesis, now taking all expenditures on dur-
ables as savings.) Still, this discussion need not be carried further. As indicated in the text,
the best method of resolving this complication is to introduce additional variables into
the multiple regression.

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 BODKIN: WINDFALL INCOME AND CONSUNIPTION 613

of the MPC's out of dividend income, discussed in the preceding para-

graphs, is now neglected.) Two interpretations of these results are pos-
sible. The first is that there is a higher marginal propensity to con-
sume, for the total population, out of windfall income than there is out
of regular income. In one view, this is a reasonable result; no provision
for contingencies or future expenditures required before the next in-
come payment arrives need be inade out of this income source. The sec-
ond interpretation is that the dividend recipients merely received some
additional income, some of which they spent. Reasoning in this manner,
onie would assert that the discrepancy between the two MPC's (from
the same regression equation) merely reflects the chance variations of
sampling. Hence a statistical test of significance is in order. For the first
regression (where consumption is defined to include expenditure on con-
sumer durables), the MPC out of the dividend income is .97, while
the MPC out of regular income is .75. The difference between these two
parameter estimates is, therefore, .22. The estimated standard error of
the difference (taking account of an estimated covariance between these
two parameter estimates) is .147. The numerical value of t, the ratio
of the difference of these two parameter estimates to the estimated
standard error of this difference is approximately 1.49. Chance varia-
tions would give rise to a discrepancy as large or larger 14 times out
of 100.
If we use the second regression (in which consumption expenditures
are defined to exclude expenditure on durable goods), the results are
quite similar. In this case, the difference between the MPC out of the
windfall dividend and the MPC out of regular income is .163. The
estimated standard error of the difference is .111. The numerical value
of t is, accordingly, 1.47. Thus the level of statistical significance is
nearly the same as before; in this case, the discrepancy is significant
at the 14.2 per cent level. It would appear that we cannot conclude, on
the basis of the data presented here, that in the entire population the
MPC out of windfall income exceeds the MPC out of regular income.
This might be merely due to an inadequate (for this purpose) size of
sample. In any case, the observed difference between the two kinds of
MPC's, while suggestive, does not appear to be statistically significant.

IV. Concluding Remarks

In summary, there appears, in spite of the reservations discussed
above, to be a strong tendency to spend windfall income. This pro-
pensity does not appear to exceed the marginal propensity to consume
regular income. Nevertheless, the true (population) value of the mar-
ginal propensity to consume out of windfall income is, in all likelihood,
quite high. This has rather interesting implications for fiscal policy. In

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614 THE AMERICAN ECONOMIC REVIEW

particular, it suggests that even a temporary tax cut would be effective

in alleviating some of the hardships of a recession. This is a point that
was widely debated in the 1957-58 downturn. The basis of this assertion
is that these data suggest that a temporary tax rebate would have its
desired effect, i.e. that it would induce about as much consumer spend-
ing as a decrease in taxes expected to be permanent.14
Finally, it would appear that consumption and windfall income are
far from uncorrelated for this body of data. Hence an important
theoretical result of the permanent income hypothesis appears to be
seriously questioned. The marginal propensity to consume out of wind-
fall income does not appear to be appreciably lower than the mar-
ginal propensity to consume out of regular income, a large part of which
would be permanent income according to the theory under considera-
tion.
This is not to assert that the distinction between permanent income
and windfall income may not prove to be a fruitful one. Indeed there
are both theoretical and empirical reasons for believing that consumers
respond differently to different kinds of income. But the postulate that
there is zero correlation between transitory income and transitory con-
sumption may not be the most satisfactory way to introduce this dis-
tinction into a theory of consumer behavior. The relationships discussed
above constitute evidence tending to cast doubt upon this particular
formulation of the permanent income hypothesis.

1 Parenthetically, it might be noted that the definition of consumption used in the perma-
nent income hypothesis may lead to confusion with regard to fiscal policy. Both expenditures
on nondurable and durable goods have expansionary effects on employment levels. Think-
ing of expenditures on durable goods as (largely) savings is likely to obscure this symmetry.
For if savings are defined from the point of view of this model, an increase in "savings"
which is mainly an increase in durable goods expenditures can lead also to increased national
income and employment.

REFERENCES
1. M. R. FISHER, "Exploration in Savings Behavior," Bull. Oxford Inst. Stat.,
Aug. 1956, 18, 201-77.
2. M. FRIEDMAN, A Theory of the Consumption Function. Princeton 1957.
3. I. FRIEND, "Some Conditions for Progress in the Study of Savings," Bull.
Oxford Inst. Stat., May 1957, 19, 165-70.
4. I. FRIEND AND I. KRAVIS, "Consumption Patterns and Permanent Income,"
Am. Econ. Rev., Proceedings, May 1957, 47, 536-65.
5. L. R. KLEIN AND N. LIVIATAN, "Significance of Income Variability on
Savings Behavior," Bull. Oxford Inst. Stat., May 1957, 19, 151-60.
6. J. TOBIN AND H. WATTS, "An Evaluation of the Tests," Bull. Oxford Inst.
Stat., May 1957, 19, 161-64.
7. Study of Consumer Expenditures, Incomes, and Savings, Vol. 1-18. Uni-
versity of Pennsylvania, Philadelphia 1957.
8. Survey of Current Business, Mar. 1950, 30, 1-3.

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