Taxes and Behavioral Economics: What People Should Do, and What People Really Do.
by Ellen Pierce
Classic economic theory is based on very specific assumptions about behavior and human biology: most people make choices with the goal of maximizing their utility. But behavioral economics is different: it studies how people actually behave, not how we think people should behave. (It also suggests ways to encourage people to act toward a social good, but that is beyond the scope of this piece.)
Behavioral economists are particularly interested when what people actually do differs from what the rational choice model (or the neoclassical model) of economic behavior predicts people will do. Studies try to understand how psychological phenomena like emotions and group dynamics influence economic decisions. It has been discovered that people often make decisions that are not in their best interest -- or at least what economists consider their best interest!
We know, for example, that people would rather get a lower salary and be the highest earner in their firm than receive a higher salary and be the lowest earner in their firm. With 401(k) accounts, people give up free money from the government because they are too lazy to walk over to the human resources department to sign a paper (yet they are also too lazy to opt out!). They will eat carrots rather than carrot cake if is first in the buffet line. People feel they "save" their money by waiting for IRS refunds.
In thinking about tax policy and behavioral economics there are two particularly interesting topics: the payroll tax and increased marginal tax rates.
Economic theory suggests that a rational person will spend very little of a temporary tax windfall (the reduction in the payroll tax.) It won't affect her long term financial well-being, so she'll use it to increase savings or pay down debt. Behavioral economists have found that people are indeed less likely to spend a one-time payment - this is considered wealth, not income - and it will be saved. However, a steady increment to a weekly paycheck over a period of time is considered income and spending will increase accordingly. But take away that increment - even if it was understood to be temporary - and suddenly we feel even poorer than we did in the first place, evidenced by overly proportionate spending cuts. This would suggest that ignoring the payroll tax cut was not a great idea.
The economic debate over raising marginal tax rates on high income earners centers on the disincentives they cause for work, saving, investment, and job creation. But will raising marginal tax rates really keep people from working?
Income tax on earned income does increase the cost of work relative to leisure, making work time less appealing and leisure time that much more attractive. But there is also another effect: by lowering disposable income, an increase in income tax may cause a person to work harder in order to maintain her previous standard of living. The net effect on income of a higher tax is therefore uncertain. People who earn high incomes tend to be highly competitive and to rate themselves by their income relative to the income of their peers. What a marginal tax rate increase may actually do, however, is increase the amount of time people spend to avoid paying the higher taxes.