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## Taxing Prospect Theory

About 30 years ago psychologists and economists began for formalize a theory called “prospect theory” in an attempt to explain  some systematic “mistakes” economic actors seemed to make on a fairly consistent basis. Simply put, prospect theory posits that humans weigh gains and losses differently, which explains why they do not behave according to what standard expected utility theory suggests.

Two classic examples of this behavior include:

1. If you were in the market for #2 pencils, and one store in town (Store #1) sold them for \$4.99 each and another store just a mile down the street (Store #2) sold the same exact pencils for \$0.99 each, consumers are very likely to head to the alternative (less expensive) store. Why? If you want to save \$3.00 on your purchase and the costs of switching stores is less than \$3.00, then it makes sense to do it.However, consider you were in the market for a laptop. You are in Store #1 and the laptop is priced at \$1299.99. While there, your friend calls you to inform you that the very same laptop could be had from Store #2 for \$1296.99. In this case, very few consumers are likely to get in the car to go save the \$3.00. But if you would have gone to Store #2 in the first scenario to get the net benefit from the \$3 price difference, why should it matter of the \$3 price difference is from spending on a big ticket item versus a small ticket item? After all, if someone asked you the question (devoid of the details), “would you spend \$1.25 in order to earn \$3.00” you would tend to answer the same way whether I asked you the question twice, three times, four times, etc.
2. Perhaps an easier to understand anomaly would be the following. Provide your preferred choice in each scenario.Scenario #1
Choice A: Win \$100 with certainty
Choice B: Have a 10% chance of winning \$1000 and a 90% chance of winning \$0

Scenario #2

Choice C: Lose \$100 with certainty
Choice D: Have a 10% chance of losing \$1,000 and a 90% chance of losing \$0.

When presented with Scenario #1, lots of people choose option A. And interestingly, we see lots of these very same people choosing option D when presented with scenario 2. This is odd, especially since Scenario 1 and 2 are virtually identical except for the flipped sign.

Prospect theory has lots to say about these behaviors. Let us not question the validity of this theory, or its range of import. Instead, let’s take it as gospel that individuals are risk seeking when it comes to losses (e.g. they prefer a gamble over a sure thing with the same expected value) and risk averse when it comes to gains (e.g. they prefer a sure thing over a gamble with the same expected value). What does this imply about other behavior – such as the idea that “the rich” do not respond to higher marginal tax rates by reducing labor supply?

Consider a worker earning \$1 million and the world has two tax rates: 10% on the first 100k and 30% on all other income. In this world, our worker would pay \$280,000 in taxes. Suppose now that the highest tax rate is raised to 50%. In this world, assuming no behavioral or market changes, his tax bill would rise to \$460,000, or an additional \$180,000.

Of course, the magnitude of the current proposed changes are much smaller than that, but these numbers make the example easy to see. The standard narrative of the left is that people respond little to these changes – i.e. they do not withhold labor market services or new business startups in response. The standard narrative of the right is that they do. And when we consider tax breaks, the left narrative is consistent – that nor do workers increase their effort when taxes fall, and the right narrative is internally consistent – that workers do increase their effort when taxes fall.

I have not swum deeply enough in the literature to say for sure, but certainly very few folks in the popular discussion give me reason to believe that the impacts they propose happen in one direction are not similar in response in the other direction. In other words, when the right argues that labor supply falls in response to a given tax increase, I suspect they would agree that labor supply would increase by a similar amount when taxes fall by a similar amount. Now there are theoretical reasons to doubt this, but I wanted to think about the behavioral implications.

If people are risk seeking in losses, or weigh losses more than they weigh gains, what does this suggest for behavior in response to tax changes? Presumably it would seem to me that the political left is more correct here than is commonly granted. If we really hate financial losses, even at irrationally large overall costs to ourselves, perhaps people work really hard when the prospect of higher taxes comes into play. And then by extension, since we are not as risk seeking in gains, perhaps our positive labor supply response is muted. At least that is what the behavioral economics literature suggests we would.

I am puzzled why, then, I do not see the left using this idea when talking about tax policy, especially when behavioral explanations for other interventions seem to curry so much favor with them? I am sure I am simplifying things and leaving things out – so what am I leaving out? Or is this just some unexploited profit opportunity for the left (i.e. markets are inefficient!)?

Lest my readers start worrying about me, this observation does not change how I feel about taxes nor does it change the macroeconomic research on the relationship between taxes and growth nor does it mean I endorse the behavioralist view.

### One Response to “Taxing Prospect Theory”

1. Rod says:

Faced with higher marginal rates, most people would look for ways to lower their tax bills, either by finding loopholes, tax shelters, or by moving capital offshore. Accountants, tax attorneys and financial planners make a living at it.

As a winter cow, you will appreciate this: back in the late 70’s, dairy cattle were expenses, so many investors with big incomes, including John Lennon, sought out high-priced holsteins to fill their barns, which were also depreciable assets. Now, these well-pedigreed cows were only valuable if they were cared for properly, so not all those neophyte investors were able to keep the wheels on these fancy cows, but heck, it was better than giving 70 percent to the government!

At any rate, it’s nonsense to say that people don’t change their behavior when faced with high tax rates. They’ll even resort to otherwise stupid investments, or, worse, go underground. Open a pizza restaurant, buy kruggerands.