I just received a performance bonus at work. It was about the size of one of my biweekly pay checks. So it isn’t anything to get too excited about. Nevertheless, I have to do something with the money. For fun let’s see what economic theory has to say about the matter.
One can’t go too far wrong by consulting Milton Friedman. He developed the permanent income hypothesis in the 1950s that says individuals will consume a constant portion of their permanent income. Under the theory, a short-term windfall, like a bonus, will have little impact on consumption. Put another way, consumers like to minimize volatility in their consumption. So they figure out what portion of their income is permanent (will continue into the future) and consume a fixed portion of that. All other income is, by definition, transitory (will not continue into the future) and is mostly saved for future consumption.
This is very similar to the concept of consumption smoothing in the lifecycle hypothesis. We try to keep the funds available for consumption constant over time. The only way to do this is to save some current income for later when one’s income is expected to decline (e.g. in retirement). Also, if one consumes one’s windfall today then consumption will not be constant. It will spike today and decline later when we do not receive a windfall.
I can’t expect a bonus in the same amount every year. Therefore, my bonus is transitory. To smooth my consumption I should spend a little today, a little next year, a little the year after that, and so on until death. The amount spent in each year should be constant in real terms. Spreading an amount equivalent to one biweekly income check over a lifetime amounts to a very tiny increase in my standard of living. This was a small bonus indeed.
In practice I don’t tend think exactly this way about a windfall. Normally I just save it all. Or that is what I tell myself I am doing. However, there are statutory limits to certain types of saving (e.g. 401(k) contribution limits, Roth IRA contribution limits) and other types of saving I do is for pre-retirement consumption, including funding the college educations I hope my children receive. That is, once I hit the retirement savings limits I am bound to consume what remains before retirement. So I will spread some fraction of my bonus over the span of years between now and retirement, which is not exactly what Friedman says I’ll do, but pretty darn close.
Having contemplated Friedman’s permanent income hypothesis and my own behavior I conclude that Friedman’s hypothesis is nearly right in my case. But what about folks who spend their entire bonus? Are they irrational or is the permanent income hypothesis not a model of rational behavior? One can over-save and fail to enjoy the fruits of one’s labor. To me that sounds less rational and more like rationalization. I’d better stop here.