Permanent Income

Win the lottery. Tap into a trust fund. Inherit the throne of some obscure but enormously wealthy country. Achieve tenure at some prestigious university...or maybe just get elected to the U.S. Senate. Those situations cover one concept of permanent income. Income that will be coming in forever, no matter what you do.

In economics, though, the concept is more particular. It's used to explain consumer spending patterns. Called the permanent income hypothesis, the model assumes that a person will spend money according to what they think their long-term average income will be. In other words, people get an idea in their head about how much they're likely to make going forward. Like...into the distant future. And that expectation drives their spending activity.

You’re an economist. We know...dare to dream. But you’re not just a run-of-the-mill, on-one-hand-and-on-the-other-hand type of economist. You are a very confident economist. Brash. Brazen. Impertinent. You just graduated last in your class from Jacksonville Online Economic Technical Institute and Culinary Academy. Still, you are 100%, without a doubt, definitely convinced that you will one day win the Nobel Prize in economics.

The Nobel Prize includes a cash award of around $900,000, depending on the year and Swedish currency exchange rates. You are positive you're going to win that someday. So, by permanent income theory, you count that in your permanent income. You’re 23 now, fresh out of Jack Econ Tech And Culinary...average lifespan is about 79 years. That gives you about 56 years to go.

Divide $900,000 by 56. That’s $16,071.43 extra that you can spend each year. You’ll have to borrow the money for now...at least until you get the call from Sweden.

Another example. You work at a factory that makes leashes and collars for pet ducks. You make $50,000 a year as a quality control inspector in the R&D department. You spend your days out back by the scientifically designed, man-made lake, leading ducks with experimental leashes.

You assume you'll keep this basic salary for the foreseeable future. Under the permanent income hypothesis, your assumed "permanent income" is $50,000. You'll spend up to that level. Now...you get some weird news. Your eccentric uncle decides he wants to give away his worldly belongings and move to a Buddhist commune in Mongolia. Your share: $5,000.

So this particular year, you brought in $55,000. You got your usual $50,000 for your job at the duck leash factory, and an additional, one-time bonus amount of $5,000 from your uncle.

Someone supporting the permanent income hypothesis would expect you to save the $5,000 from your uncle. You know the $5,000 is a one-time bonus. Your uncle has moved to the Buddhist commune and doesn't have any more money to give away. You don't have any other uncles.

Point is: the $5,000 gift is not likely to repeat. Your perception of your long-term "permanent income" hasn't changed. You still expect to earn $50,000 a year long-term. So you sock the $5,000 away for a rainy day. Next year, you get a promotion. You are now head of the duck collar quality control department. Your salary rises to $85,000. Your expectations rise as well.

You assume you'll be head of the department for the foreseeable future. You don't save the additional $35,000 in salary. You're happy to spend it. You trade in your Yaris for a Cadillac, and you skip the $5 wine rack for stuff in the $20 aisle.

Your new assumed permanent income has changed. Now you perceive $85,000 as your permanent income...so you spend accordingly. You buy a diamond collar for your own pet duck. Maybe a little extravagant, even for $85,000 a year. But you did get to use your employee discount.