The permanent income hypothesis (PIH) is an economic concept in analyzing the consumers’ behavior which argues that people base consumption as a proportion of their normal income. Consumption will always depend on the amount the consumers expect to earn for a certain period. People tend to save more during the periods of high income and spend more during the periods of high income. According to Friedman who proposes the theory people, tend to base their income of the previous several years to come up with their permanent income. For instance if a consumer’s income for the past four years was $14,000, $10,000, $12,000, $11,000, and $9,000 then their permanent income would be $11,500. Wealth is normally the present discounted value of current and the receipts of the future income including any income from assets. Permanent income ¥ =?? where ? represents the real interest rate. Testing the PIH can be difficult as permanent income is not observable and can only be estimated. The theory also omits some details such as demographics and retirement it is model’s life cycle. The individual’s lifetime income determines peoples’ consumption and not the current income. Temporary tax cuts have a large stimulating effect on demand and the PIH framework argues that any consumer will spread out the profits from the temporary tax cut over a long horizon.

Changes in the peoples’ consumption behavior may not be predictable as they base them on expectations, which affect the economic policy. Economic policies may be successful in increasing the income in the economy there should be no expectations for increased spending until reform their expectations concerning their future incomes. The PIH assumes that there exist an adaptive relationship between permanent and measure income. PIH policy assumes that current income has a minor role in determining the consumption for current and future income. The saving changes may reflect transitory income movements since capital markets do not have reliable shorter borrowing and lending opportunities. The PIH assumes that the capital markets are perfect and the lenders can give credit based on the repayments with future income that is yet to be received at an interest rate. Any rise in incomes may be used for financing increased consumption.

Tax cuts have the effect of stimulating the aggregate demand and surplus as lower taxes make the current working more attractive than the future working increasing the labor supply. Tax cutting will not therefore narrow the gap between the output and the amount the citizens produce. The assumption is that consumers may not respond to tax changes unless they are sure that the change will be lasting for long. Consumers adjust their spending before the change starts affecting the tax payments thus changes in the legal structure of tax liabilities influence consumers spending more that any changes in the timing of tax payment. For instance in 1975, temporary changes in the income tax were enacted to boost spending by increasing the income of the consumers. The package consisted of a rebate check of $50, which was sent to each individual income taxpayer in may 1975. The result was an increase in personal savings meaning that very little of the rebate was actually spent. The 198 tax cut with three permanent cuts in federal income tax of 5%, 10%, and 10% in 1981, 1982, and 1983 respectively. The saving rate declined only towards the end of 198 and decline continued toward through the first half of 1983. The changes in incomes due to the tax cuts had little effect on the spending of the consumers as in some cases there was increased savings.