Transfers and Development Easy Come , Easy Go ?

A central behavioral assumption of economic theory is that income is fungible. Yet, building on the pioneering work by Thaler (1999) recent work by behavioural economists highlights that people code income in different mental accounts, creating a direct link between spending behaviour and income sources, thereby violating the fungibility assumption. This paper examines whether the marginal propensity to consume differs depending on the source of income in a developing country setting. It further focuses on a form of mental accounting which has received little attention, i.e. the coding of income in line with the amount of effort dispensed. In particular, it examines the differences in the marginal propensity to consume among earned and unearned incomes, using a 5-year household panel of 1500 households in two provinces in rural China. The results indicate that households have a higher marginal propensity to spend unearned income on consumption items. On the other hand, households also display a higher marginal propensity to spend earned income (and loans) on productive assets and investment in the family business. This evidence from observed demand behaviour lends support to the psychologically grounded choice theory of mental accounting and has important policy implications. Heeding the advice from the age-old saying ‘Easy come, easy go’ may be time well spent in future theoretical and empirical work. 1 The authors would like to thank the Chinese authorities of the World Bank’s Western Poverty Reduction Project in China (WPRP), Wang Pingping, Assistant Counsel, Department of Rural Surveys of the National Bureau of Statistics of China, and Sari Söderstrom, World Bank Task Manager of the WPRP for making the data available. 2 United Nations University – World Institute for Development Economics Research (UNU-WIDER); Katajanokanlaituri 6 B, FI-00160 Helsinki, Finland; tel. +358 96599213; [email protected]. 3 Development Economics Group, Wageningen University and Research Centre; Hollandseweg 1, 6706KN Wageningen, The Netherlands; tel. +31 317484354; [email protected].