Should the government nudge people to improve their decisions?

What is a nudge? In their book, “Nudge”, Richard Thaler and Cass Sunstein define a nudge as “any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing economic incentives” (p 6).

Thaler and Sunstein claim that nudges are consistent with libertarianism because they don’t involve coercion but they readily acknowledge that nudges are paternalistic. They advocate "libertarian paternalism".

An example might help to clarify what a nudge involves. If the government were to invest a certain proportion of your income in a superannuation fund on your behalf this would amount to a nudge (rather than a push or a shove) if you were allowed to withdraw the funds at any time to use as you wished. There is evidence that as a result of a tendency for people to avoid choices (or to choose the default options) such an arrangement would result in much more investment in superannuation than one that relied solely on tax incentives. It would do this without the interference in personal choice that is involved in compulsory superannuation, such as exists in Australia.

After reading “Nudge” I decided to read some reviews by other people to help clarify my own views. The basic idea that people’s behaviour can be influenced by so called “choice architects” seems to be widely accepted by reviewers. This does not surprise me because there is no real conflict between the conventional view of economists (as argued, for example by Tim Harford in “The Logic of Life”) that people respond to incentives and the view of psychologists and behavioral economists (for example, Dan Ariely) that people are “predictably irrational”. For elaboration, see here.

Some reviewers taking what seems to me to be a predictably irrational approach, attack Thaler and Sunstein for rejecting coercion. For example, in the New York Review of Books. John Cassidy argues: “Once you concentrate on the reality that people often make poor choices, and that their actions can harm others as well as themselves, the obvious thing to do is restrict their set of choices and prohibit destructive behavior” (see here). The fallacy in this argument was aptly described by Harold Demsetz as “the grass is always greener” fallacy (‘Information and efficiency: another viewpoint’, Journal of Law and Economics, 1969) . Cassidy seems to be claiming that if outcomes are imperfect when choices are not restricted they must necessarily be better when choices are restricted. Social experiments with prohibition of alcohol early last century and Keynesianism from World War II until the stagflation of the1970s should have taught everyone that government interventions do not always result in better outcomes.

Some other reviewers attack Thaler and Sunstein for being paternalistic. For example David Gordon of the Mises Institute argues: “Those who wish to preserve liberty must take people's actions as they find them, not substitute for them "better" or more "rational" actions, based on an assessment of what people "really" want.” He suggests that: “Those who find convincing the explanations of bad choices put forward by Thaler and Sunstein are free to make arrangements with others that will alleviate these problems. If you think that sudden impulses when confronted with tempting food will lead you to fall off your diet, you may contract with a friend to forfeit money should you fail to meet certain weight requirements. But, in a free society, doing so is up to you; the state may not nudge you into this sort of contract” (see here).

Although I have a great deal of sympathy for Gordon’s line of argument, I don’t think it settles the question. Even though I vote to preserve my liberty - and am prepared to accept the consequences - that doesn’t stop the majority of people from voting in favour of government action to nudge their decisions (and mine) in particular directions. I will consider the implications of this in my next post.

Are the top 100 taxpayers particularly virtuous?

When I decided to write this a couple of days ago I had the impression that the Australian tax commissioner had sent a letter to Dick Smith, a successful Australian businessman and aerial adventurer, threatening him with dire consequences if he did not refrain from use of legal tax avoidance measures. As I gathered information together, however, a rather different story emerged.

The best place to begin is with the late Kerry Packer, who was the wealthiest person in Australia. When asked by a government member about his company's tax minimisation schemes (during a public inquiry in 1991) Packer famously replied:

"Of course I am minimising my tax. And if anybody in this country doesn't minimise their tax, they want their heads read, because as a government, I can tell you you're not spending it that well that we should be donating extra!"

A couple of weeks ago it seemed that Dick Smith had finally decided to follow Kerry Packer’s lead. Smith wrote, in a letter to the tax commissioner, that he didn’t agree with Packer’s statement at the time it was made “but I certainly do now”.

Smith’s letter to the tax commissioner was in response to a brochure sent to 1200 wealthy Australians. Having just looked at the brochure, merely out of curiosity, it seems to me that there is nothing particularly objectionable in it. The main message seems to be that it is important for wealthy people to get good advice about tax matters.

However, in his letter Smith made clear that what had led him to change his mind was a particular instance of waste and mismanagement in relation to defence procurement. It seems that the tax commissioner was just a convenient target for Smith’s letter.

When I first read the newspaper articles suggesting that Dick Smith had become a convert to Kerry Packer’s views on government spending and tax minimisation I thought this meant that he was about to put his considerable skills in capturing public attention to use in making the case for smaller government and lower taxes. I was wrong.

An article in “The Australian” on Monday indicates that Smith has now told the tax commissioner that he will not be “entering into any scheme to legally minimize my tax”. What did the commissioner do to get Smith to change his mind? It seems that he just appealed to Smith not to do anything that could reduce community confidence in the tax system.

So, how did Smith respond? Well, it seems to me that Smith’s response was the human equivalent of a puppy that whines until it gets attention and then rolls over onto its back and asks to have its tummy tickled. Smith asked the tax commissioner to publish a list of Australia’s 100 top taxpayers in order to give them recognition for their efforts. His reasoning seems to be that anyone in the list of Australia’s 100 top taxpayers must be a particularly virtuous person who deserves recognition for, in effect, volunteering to pay more tax than he/she is legally obliged to pay.

What nonsense. Some wealthy people who take advantage of opportunities legally available to avoid tax, in their efforts to maximise post-tax income, might still be included among the top 100 taxpayers. Moreover, it is possible for wealthy people to minimize their tax as a consequence of altruism rather than selfishness – people pay no income tax if they donate all their income to registered charities.

What was Alan Wood's final message as economics editor of "The Australian"?

At the end of his column in “The Australian” today, Alan Wood told readers that this was his final column as economics editor.

So, what message did Alan view as sufficiently important to be the subject of this column?

I quote what seems to be Alan’s main point:
“If Australia moves ahead of the rest of the world to curb carbon emissions, there will be no benefit to Australia or the world but a potentially very high cost to us, involving extensive restructuring and transfers of wealth within Australia and from Australia to emerging economies.”

I think that message is worth repeating. The rest of the column can be read here.

What does happiness research tell us about the trade-off between inflation and unemployment?

The best place to begin is with the misery index. What is the misery index? No, it isn’t a measure of the average happiness level of economists. The misery index is the sum of the inflation rate and the unemployment rate. The concept was apparently created by Arthur Okun in the 1960s (see here) but it wasn’t the best idea he ever had. (Arguably, Okun’s best idea was the ‘leaky bucket’ metaphor. Redistribution of income from the rich to the poor is like carrying water in a leaky bucket. Some of the contents of the bucket is lost in transit. More information can be found here.)

The problem with the misery index is that it assumes that a percentage point increase in inflation creates just as much misery as a percentage point increase in unemployment. That assumption might make some sense if we had no information about the relative amounts of misery caused by inflation and unemployment, but that is not the case.

The results of happiness research suggest that unemployment has large negative effects on satisfaction with life. Research suggests that an increase in annual income of over $40,000 (over and above unemployment benefits) would be required to give Australian males who are unemployed the same probability of experiencing high life satisfaction as someone who is employed. The corresponding income increase for women was estimated to be about twice as large (for reasons unknown). Larger required income differences have also been estimated for other countries (see Nick Carroll, ‘Unemployment and psychological well-being’, Economic Record, Sept. 2007).

Happiness research suggests that although inflation has significant negative effects on satisfaction with life these effects are smaller than the effects on unemployment. Using a large European data base, Justin Wolfers has estimated that a percentage point of unemployment causes about 5 times more unhappiness than a percentage point of inflation (‘Is business cycle volatility costly’, International Finance, 2003, here).

If we can assume that a similar ratio applies in Australia, would this mean that the Reserve Bank would have to be crazy to contemplate policy action that would reduce inflation by a percentage point if this was likely to result in an increase in unemployment of 2 percentage points? No. In order to do this calculation properly it is necessary to take into account the duration of these expected effects of policy actions. If the reduction in inflation is expected to be permanent and the increase in unemployment is expected to last for only one year, the policy action would make sense. A clever politician might even be able to sell such an outcome to the public as “the recession we had to have”.

The obvious point is that if the Reserve Bank is able to demonstrate its resolve to prevent inflationary expectations from taking hold it will be able to avoid resorting to the unpalatable option of inducing a recession in order to reduce inflation. Unfortunately, the Bank is under pressure from some economists to view recent increases in inflation as having been “imported” and hence to take no action against them. I don’t know how anyone can argue that inflation can be imported in a country that has a floating exchange rate - but that may not mean much because I still count myself among those who think that “inflation is always and everywhere a monetary phenomenon”.