Economy / Fiscal policy / Tax / Taxes

Tax Cut-Implications for Behavioral Economics

Richard H. Thaler, professor of behavioral science and economics at the University of Chicago, won the Nobel Prize in Economic Sciences this year “for his contributions to behavioral economics.” This is a relatively new field that combines the idea of psychology and economics. Standard economic models assume that humans are rational actors. However, behavioral economists like Thaler breaks this assumption, arguing that humans are imperfectly rational. I will talk about how we can rethink aspects of the standard economic approach to government stimulus by incorporating the idea of endowment effect and fairness.


There has been a debate on which stimulus is better: tax cuts or spending. Traditionally, conservatives favored tax cuts while liberals favored more spending. President Trump and the “Big Six” Republic negotiators recently released the unified framework on tax reform, which includes a plan to cut the corporate tax rate from 35% federal statutory rate to 20-25%. The plan also includes nearly doubling the standard deduction for individuals and married couples. In the end, this would lead to $1.5 trillion tax cut. Is this a better stimulus than spending?


In standard economic models, preferences between two goods are independent of the consumer’s current entitlements. Thus, indifference curves are drawn without reference to current endowments. However, according to behavioral economists like Kahneman, Knetsch, and Thaler (1990), “when the good becomes part of the individual’s endowment, there is an increased value of a good to that person (the endowment effect). This effect is a manifestation of ‘loss aversion,’ the generalization that losses are weighted substantially more than gains”. For example, the value that an individual assigns to such objects as mugs or chocolate bars increase substantially as soon as that individual is given the object. Once students were endowed with any of these objects, they are reluctant to trade with others.


Under standard economic model assumptions, the government should be indifferent between a tax cut and spending if the same amount is taxed or spent. Both increase government debt and are gains to the society as a whole yet in different forms. If the government cuts taxes, Americans would have more money to spend. If the government increases spending, more government money would be pumped into the economy through ways such as transfer payments for social security, welfare, and other needs.


However, some policymakers regard tax cut as a larger stimulus to the economy. If behavioral economists were right, the implications of this would be that since people are loss averse, the disutility associated with an outcome that is coded as a loss of income (paying tax) may be greater than the disutility of the same objective outcome when coded as the loss of transfer payments such as Medicare (spending cut). In other words, people would be happier with less loss (tax cut) than more gains (spending). For the same reason, in community standards, it is not “fair” to raise taxes even during periods of recession just like how firms do not cut wages during a recession.


In conclusion, the behavioral economist’s argument may support some policymakers’ preference for tax cut over spending. The endowment effect and fairness show that how people respond to taxes and spending is less straightforward than the standard model supposes. Imperfectly rational individuals will respond to taxes and spending in a way that is mediated by psychology. In this blog, I have neglected how the impact of the tax cut and spending varies over income groups–tax cuts may help the rich more because it can lead to a reduction in government services upon which lower-income people rely. Other effects may complicate the preference. But incorporating the psychological factor would certainly help guide policymakers better assess the aggregate impact and guide towards a smarter policy.