Behavioral Public Finance

Behavioral Public Finance

Edward J. McCaffery
Joel Slemrod
Copyright Date: 2006
Published by: Russell Sage Foundation
Pages: 416
https://www.jstor.org/stable/10.7758/9781610443852
  • Cite this Item
  • Book Info
    Behavioral Public Finance
    Book Description:

    Behavioral economics questions the basic underpinnings of economic theory, showing that people often do not act consistently in their own self-interest when making economic decisions. While these findings have important theoretical implications, they also provide a new lens for examining public policies, such as taxation, public spending, and the provision of adequate pensions. How can people be encouraged to save adequately for retirement when evidence shows that they tend to spend their money as soon as they can? Would closer monitoring of income tax returns lead to more honest taxpayers or a more distrustful, uncooperative citizenry? Behavioral Public Finance, edited by Edward McCaffery and Joel Slemrod, applies the principles of behavioral economics to government's role in constructing economic and social policies of these kinds and suggests that programs crafted with rational participants in mind may require redesign. Behavioral Public Finance looks at several facets of economic life and asks how behavioral research can increase public welfare. Deborah A. Small, George Loewenstein, and Jeff Strnad note that public support for a tax often depends not only on who bears its burdens, but also on how the tax is framed. For example, people tend to prefer corporate taxes over sales taxes, even though the cost of both is eventually extracted from the consumer. James J. Choi, David Laibson, Brigitte C. Madrian, and Andrew Metrick assess the impact of several different features of 401(k) plans on employee savings behavior. They find that when employees are automatically enrolled in a retirement savings plan, they overwhelmingly accept the status quo and continue participating, while employees without automatic enrollment typically take over a year to join the saving plan. Behavioral Public Finance also looks at taxpayer compliance. While the classic economic model suggests that the low rate of IRS audits means far fewer people should voluntarily pay their taxes than actually do, John Cullis, Philip Jones, and Alan Lewis present new research showing that many people do not underreport their incomes even when the probability of getting caught is a mere one percent. Human beings are not always rational, utility-maximizing economic agents. Behavioral economics has shown how human behavior departs from the assumptions made by generations of economists. Now, Behavioral Public Finance brings the insights of behavioral economics to analysis of policies that affect us all.

    eISBN: 978-1-61044-385-2
    Subjects: Finance, Sociology, Political Science

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Contributors
    (pp. vii-viii)
  4. PART I PSYCHOLOGY, ECONOMICS, AND ECONOMETRICS
    • Chapter 1 Toward an Agenda for Behavioral Public Finance
      (pp. 3-31)
      Edward J. Mccaffery and Joel Slemrod

      This chapter is about the intersection—or the possible intersection—between the fields of behavioral economics and public finance, which we call behavioral public finance. Public finance is a venerable field in the economics fold. Its positive and normative branches rest on two basic assumptions. One, and central to public finance’s positive agenda, is that individuals are rational, maximizing agents, in the simple sense that they act consistently on the basis of a well-defined utility function.¹ We call this the rationality assumption. Two, and central to public finance’s normative agenda, is that the basis for evaluating social policies should be...

    • Chapter 2 Statistical, Identifiable, and Iconic Victims
      (pp. 32-46)
      George Loewenstein, Deborah A. Small and Jeff Strnad

      In the ideal vision of public finance, each dollar of government spending is allocated to the area where it can do the most good, and taxes are levied and revenues spent to the point where the marginal value of a public dollar is equal to that of a private dollar. Reality falls short of this ideal in many ways. The political system doesn’t necessarily aggregate preferences the way a market would; politicians and government workers may be corrupt or have their own personal agendas; and different groups have different incentives and capabilities to coordinate and lobby for their interests.

      Here...

    • Chapter 3 Distinguishing Between Cognitive Biases
      (pp. 47-82)
      Hanming Fang and Dan Silverman

      Economists have recently taken increased interest in a number of cognitive biases and heuristics first documented by psychologists.¹ In theoretical studies, economists typically introduce such biases and heuristics into stylized models with a goal of understanding how small, but psychologically relevant, deviations from the standard economic framework can influence decisions such as saving and consumption (Harris and Laibson 2001), investment (Barberis and Huang 2001), and labor supply (Fang and Silverman 2004a). In empirical studies, economists have followed two basic strategies. The first is to derive distinctive empirical implications from a model of a particular bias or heuristic and then check...

  5. PART II BEHAVIOR AND POLICY
    • Chapter 4 Masking Redistribution (or Its Absence)
      (pp. 85-112)
      Jonathan Baron and Edward J. McCaffery

      Behavioral economics considers the ways that actual people make economic decisions and take economic actions (Thaler 1980; Kahneman and Tversky 2000; Sunstein 2000). In a nutshell, people make mistakes, showing inconsistent judgment in the face of framing and other formal manipulations of the presentation of choice problems. Most everyone, it seems, likes the glass half full; few like it half empty.

      Behavioral public finance, we believe, ought to consider how ordinary people think about specifically governmental actions, paradigmatically tax and spending programs. Our experiments have shown that, in general, people suffer from much the same heuristics and biases in thinking...

    • Chapter 5 Mispredicting Utility and the Political Process
      (pp. 113-140)
      Bruno S. Frey and Alois Stutzer

      Individual decisions involve difficult trade-offs between pursuing material wealth, status, and fame on the one hand and, on the other, investing in social relationships and choosing activities that provide autonomy and the experience of competence. There is an increasing belief that people systematically err in these decisions and spend too much time, effort, and money on goods, services, and activities with strong extrinsic attributes (Scitovsky 1976; Frank 1999; Easterlin 2003; Layard 2005).

      We argue that this tendency is attributable to systematic misprediction of utility. When people make decisions, they mainly take salient extrinsic attributes of choice options into account. They...

    • Chapter 6 Hyperopia in Public Finance
      (pp. 141-172)
      Lee Anne Fennell

      Human time preferences are complicated. People often seem to behave myopically, placing a heavy premium on present consumption over future consumption (see, for example, Baron 2000, 470). However, at other times, people appear to do just the opposite, weighting future payoffs more heavily than present ones (Loewenstein 1987; Loewenstein and Prelec 1991). This latter category of behavior has been termed “far-sighted” (Loewenstein 1987) and “hyperopic” (Kivetz and Simonson 2002, 201, 214).¹ Although myopia has received much greater attention in the cognitive literature, behaviors consistent with hyperopia have been identified as well (see, for example, Prelec and Loewenstein 1998, 19). Here...

  6. PART III TAX COMPLIANCE
    • Chapter 7 Value Added Tax Compliance
      (pp. 175-205)
      Paul Webley, Caroline Adams and Henk Elffers

      Over the last fifteen years there has been a considerable research into tax compliance (Andreoni, Erard, and Feinstein 1998). Many new theoretical models of the compliance process have been devised and a wide range of empirical studies carried out. But the focus of most of this research has been personal income tax compliance. Business tax evasion in general, and VAT compliance in particular, have received very little attention indeed (for a review of research on tax compliance by businesses, see Webley 2004). This is surprising given the economic and social importance of business taxation and the fact that VAT has...

    • Chapter 8 Trust and Taxation
      (pp. 206-232)
      Terrence Chorvat

      One of the perennial questions in the literature on tax compliance is what causes people to pay taxes (see Slemrod 1992). This question arises because, if one applies standard game theory or almost any rational choice approach to the problem of tax compliance, the level of the penalties and enforcement that we see in the United States would appear to be insufficient to explain the degree of compliance with the tax laws that we observe.¹ As discussed earlier in this volume, for the level of compliance that we observe to occur, one or more of the assumptions of these models...

    • Chapter 9 Tax Evasion: Artful or Artless Dodging?
      (pp. 233-258)
      John Cullis, Philip Jones and Alan Lewis

      If, as Hegel observes, “The rational is the highroad where everyone travels, where no one is conspicuous” (cited in Knox 1952, 230), then that highroad is surely not sign-posted with the axioms of expected utility theory. Rather it is littered with an array of partially analyzed, yet systematic, heuristic responses. The likes of transitivity, strong separability, and the usual rules for combining lotteries have to be replaced by a value function, framing effects, and subjective probabilities that are the product of all sorts of systematic distortions. If these sentences capture the main thrust of behavioral economics, they are relevant when...

  7. PART IV RETIREMENT BEHAVIOR
    • Chapter 10 Accounting for Social Security Benefits
      (pp. 261-303)
      Howell E. Jackson

      For most working Americans, Social Security benefits represent a significant financial asset, in many cases their principal or sole source of retirement income.¹ According to the Social Security Administration (SSA), the aggregate present value of Social Security benefits promised to those age sixty-two and older was $4.3 trillion dollars in January 2003 (U.S. Social Security Administration 2003). Economists sometimes refer to this figure as the “Social Security wealth” of retirees. Under current statutory formulas, younger workers are also entitled to substantial Social Security benefits with an aggregate present value on the order of $7.4 trillion as of 2003.² The total...

    • Chapter 11 Saving for Retirement on the Path of Least Resistance
      (pp. 304-352)
      James J. Choi, David Laibson, Brigitte C. Madrian and Andrew Metrick

      Over the last twenty years, defined contribution pension plans have gradually replaced defined benefit pension plans as the primary privately sponsored vehicle for retirement income. At year-end 2000, employers sponsored over 325,000 401(k) plans with more than forty-two million active participants and $1.8 trillion in assets.¹

      The growth of 401(k)-type savings plans and the associated displacement of defined benefit plans have generated new concerns about the adequacy of employee savings. Defined contribution pension plans place the burden of ensuring adequate retirement savings squarely on the backs of individual employees. However, employers make many decisions about the design of 401(k) plans...

  8. PART V RESERVATIONS
    • Chapter 12 Second-Order Rationality
      (pp. 355-390)
      Richard A. Epstein

      For much of my academic career I have defended a version of libertarian theory of limited government, a government whose central function is protection of private property and voluntary exchange against force and fraud (see Epstein 1985, 1995, 1998, 2003). This recognizes a role for taxation and eminent domain, not only for the common defense but also for creating infrastructure and controlling and regulating monopoly power. The battle between rational choice theory and behavioral economics—and the common errors shared by both—often calls that classical liberal theory into question on two key issues. The first is the level of...

  9. Index
    (pp. 391-408)