You’ve probably been in this situation before – money’s a bit tight, but you’re getting by. You feel sure that with just a little more monthly income, you’d finally be able to get some traction. Yet when the raise or new job comes, the situation turns out a bit more complex – and less rewarding – than you hoped. And it’s thanks to something known as the income effect.
The income effect is a phenomenon that causes income increases not to go nearly as far as we hope they will. Increasing household income can potentially be great news and create new possibilities. But without balancing out the income effect, a raise can cause serious stress – or even backfire financially.
What Is the Income Effect?
The income effect is a microeconomics term describing how consumer behavior can change based on income. Generally, when a person’s income grows, such as through a raise, promotion, or inheritance, they will quickly adjust their expectations of what they can afford or want to buy.
For instance, a person might make a large one-time purchase, such as a vehicle or vacation, after a rise in income. They may also incur new ongoing expenses like subscriptions or memberships to various clubs, facilities, and services. The income effect can also shift a person’s preferences on everyday goods like groceries. People are more likely to opt for more expensive brands and products when they feel they can afford the difference.
There’s nothing wrong with reasonable increases in lifestyle spending as your income level rises; you’ve worked for that money, and you deserve to enjoy it.
The problem with the income effect is that it clouds reasonable judgment. It’s easy to overestimate the impact a particular raise will have on your disposable income. As a result, it becomes a slippery slope to spending all (or even more than all) of your new income and ending up with more money struggles than before.
Example of the Income Effect
Let’s illustrate the risk the income effect creates with an example.
Jeff lives on his own and does okay financially. His $65,000 salary is enough to pay his rent and groceries, go out with friends sometimes, and cover the occasional Amazon impulse-buy. Things are a little tight, but he manages.
When Jeff gets a $5,000 raise to $70,000 annual pay, he’s sure it’s enough to get him where he wants to be. He’ll finally be able to set a little money aside every month and still afford a few extra comforts.
In his excitement, Jeff books a celebratory trip totalling $2,000. He also joins a new gym for $50 per month. And almost without noticing, he starts giving himself a little more leeway to buy more expensive groceries, ticking up his bill by $25 a week. Then, ready to start watching the savings roll in, Jeff discovers he is – losing almost $60 every month?!
Jeff’s change in income led to a disproportionate shift in demand. After taxes and retirement deductions, his $5,000 raise only increased his annual take-home pay by about $3,200. But he increased his spending by at least $3,900. Instead of giving Jeff more options, this promotion gave him more worries, and that’s why it is crucial to be wary of the income effect.
How the Income Effect Impacts Your Finances
We often say here that income is far from the only factor in improving one’s financial situation over time. It can be a significant factor, but because of the income effect, growing your income may have no impact at all on wealth-building. This trend is why a solid saving habit and a frugal mindset are essential no matter your salary level.
However, the income effect isn’t all-powerful. You can learn to adjust for it. And fortunately, because of the nature of income changes, you’ll usually be able to plan ahead before they take effect.
After understanding the income effect, it’s tempting to take a pretty grim view of things. So do things never get better? Are we perpetually torn between financial stability and any form of material reward?
Admittedly, this topic may tarnish the shine of your next well-earned raise. But it doesn’t have to be a detriment to your financial future or quality of life. Here’s how you can strike a healthy balance.
Countering the Income Effect
If all this talk is casting a dark cloud over the idea of getting a raise, don’t worry. Growing your income is great news. And with a little bit of planning, you can ensure that evolving your lifestyle a bit doesn’t have to come at the cost of your financial goals.
Here are a few things to consider next time you experience an income change to avoid the harmful impact of the income effect.
When a change to your paycheck is coming, you’ll want to set clear expectations about what that change will look like. If the income change has already taken effect, then check your pay stubs or bank account to see exactly how much your take-home pay has changed.
If you don’t have the exact number yet, you can estimate it with some quick math:
- Start with the total annual change to your income (whether it’s a raise, one-time windfall, etc.)
- Reduce that number by how much you expect to go to taxes (don’t worry about getting this penny-perfect; 30% is a reasonable ballpark number for most middle-income households).
- Next, adjust for any other deductions like retirement account contributions.
- Divide the result by 12.
After following these steps, you’ll have a rough estimate of how much your monthly income will change. In many cases, at least for payroll raises, this number will likely land somewhere in the $100-500 range.
That number might not be the fast track to a yacht and a vacation home. Still, it can make a significant positive impact on both your finances and your quality of life if you look at it realistically and use it intentionally.
Pay Yourself First
If you ask a typical person how an extra $200 a month would make their life easier, more comfortable, or more luxurious, they’ll have no shortage of ideas. Most of us could think of ways to spend an extra $5,000 a month without difficulty.
However, the trick to finding room to save in your budget is to make that room first.
For instance, if you will start bringing in an extra $200 a month, start by deciding how much of that you’d like to save. $25? $100? When you start by making room for that number, life will be easier and more flexible when you decide what to do with the rest later.
Make Room to Enjoy It
Usually, the most responsible choice after an income change is to keep your lifestyle spending relatively stable and use as much of the difference as possible for furthering your money goals. Still, having a little fun and enjoying yourself a bit along the way is more than okay.
Next time you experience an income jump, try to make at least a little room to enjoy something fun in the short term.
Whether it’s a one-time purchase, a weekend trip, or signing up for a new streaming service, don’t forget to treat yourself a little! As long as you keep the amount in perspective and lock in your savings goals first, there’s nothing wrong with remembering to celebrate the wins along the way.
As well as being a source of a small jolt of happiness in the short-term, making room to be flexible and treat yourself is crucial for long-term financial progress. By making room for financially healthy habits alongside spontaneous enjoyment, you make the process more enjoyable and make it easier to stay on track for the long term.
Don’t Let the Rising Tide Sink Your Ship
A growing income is a great thing and should be a central goal in improving your household finances. However, increases in income can often bring new financial hardships rather than flexibility and freedom.
The income effect is one of those peculiar cognitive biases that can turn a good thing sour and impact everyone at one point or another. Fortunately, it’s not some evil, unknowable force destined to sabotage your financial goals. It’s a common blind spot that is easy to check once you know it’s there. Set realistic expectations, and plan for your income increases in advance, and the income effect will quickly lose its power over you.