Saturday, September 19, 2009

Taxation and behavioural economics

I have blogged in earlier posts about the relevance of behavioural psyhology in formulating tax policies. Now, in a Brookings working paper, William J. Congdon, Jeffrey R. Kling, and Sendhil Mullainathan (via Freakonomics) explore the implications of deviations from the rational and self-interested utility maximizing agent of neo-classical economics due to cognitive biases and time-inconsistency problems, on tax policy.

They argue that imperfect rationality of human beings means that they choose sub-optimally, bounded self-control comes in the way of their realizing their intentions, non-standard preferences means that they care about the welfare of others and fairness and form their preferences around reference points (both in time and space).

Contrary to convetional wisdom that advocates simplicity in tax policy, behavioural psychology leads us to favoring certain types of nuanced complexity, especially in promoting welfare and fairness. For example, sales taxes (which are not posted on the good sold) and electronic toll fees (through E-Z Pass) are not salient and therefore pass through un-noticed, separately identified taxes to fund specific benefits are easier to levy, tax credits enable targetting and thereby optimize provision of subsidies.

They also point to the possibility of leveraging the automaticity inherent in tax administration (like deduction at source, and simplicity of tax filing channels) especially to take advantage of the imperfect rationality of tax payers. This can be used to facilitate automatic access to transfers and certain types of direct subsidies along with tax filings, encourage retirement and personal savings (eg channel tax refunds into default savings accounts), and have opt-out insurance policies.

About the relevance of such behavioural deviations from standard assumptions for fiscal policy, they argue that tax cuts presented as "bonus" might be more likely to be spent than tax cuts presented as a "rebate", since when individuals perceive the tax cut as a gain (a 'bonus') rather than as a foregone loss (a 'rebate'), they are more likely to spend the tax cut. Further, there is evidence that tax cuts delivered through reduced (monthly) withholding, as against lump-sum rebate or bonus, is more likely to be spent.

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