This paper presents a life-cycle model with earnings risk, liquidity constraints, and portfolio choice over tax-deferred and taxable assets to evaluate changes to household consumption in response to transitory, anticipated income shocks, such as the 2001 federal income tax rebate. Households optimally hold a large share of savings in tax-deferred assets, which are encumbered by withdrawal penalties, and choose to relinquish some taxable precautionary savings in exchange for higher after-tax returns. The model predicts an increase of several percentage points in the marginal propensity to consume out of the tax rebate compared with results from a standard frictionless life-cycle model. Moreover, the model’s liquidity-constrained households—which include households with very few financial assets and those whose portfolios are expensive to reallocate because they contain sizeable tax-deferred investments—consume a higher fraction of the tax rebate than do other types of households. The results presented are in keeping with empirical findings published in the literature concerning the 2001 federal tax rebate.
