Expiring Tax Cuts and Angry People

Towards the end of 2010, President Obama and the outgoing Congress passed several key pieces of legislation, and among them was a temporary payroll tax cut. This applies to the Social Security (FICA) tax, and since it is an immediately visible tax decrease on every paycheck for everyone (rather than a lump sump amount received at tax filing time), the argument was that this was a strong and visible stimulative measure. Due to its popularity, it was extended for another year. Finally, in January 2013, payroll taxes reverted to what they used to be.

This whole exercise has been interesting to me. Talking to people, they unambiguously think of this as a tax rise, and they have been complaining that their paychecks have gotten smaller. They don’t seem very mindful of the fact that the rate is simply going back to what it was for the longest time, and that the tax cut was always there solely as a temporary measure. Rather than think of the 2 years in which they paid lower taxes as a net gain for their personal finances, they seem mostly pissed off that this didn’t continue forever. Moreover, I can’t help but feel that if this tax cut had never occurred, then in January 2013, from a psychological standpoint, they would feel much better than they do under the current circumstances of having seen a tax cut expire. This behavior is pretty irrational from a traditional economics perspective. After all, in one scenario, they were able to keep about 2% more of their paychecks for 2 entire years. In the other scenario, they would not have had that. And yet they probably wouldn’t have been pissed off as they are now.

This is more than just an intuition I have. I have been reading Daniel Kahneman’s excellent book, Thinking, Fast and Slow. Kahneman is a psychologist by training but throughout his career he has ventured into behavioral economics with great success, and he won the Nobel Prize in Economic Sciences in 2002. Part of his work focuses on prospect theory, an alternative way of thinking about decision-making in contrast to the rational system at the core of much of traditional economics.

In the traditional model, you compare two wealth states to assess utility. Preferences are symmetric, in the sense that moving from $30,000 to $20,000 is the same as the negative of moving from $30,000 to $40,000. But this symmetric feature clearly has its failures.

Another feature in the traditional theory relates to expected value calculations in decision-making. So if you had the choice of taking $800 for certain, or if you had a 90% chance of making $1000 (and 10% of making 0), most people actually go for the certainty of $800 even though the expected value of the other trade is $900.

With gambles, people exhibit loss aversion. So if someone had a 50% chance of losing $100 and a 50% chance of winning $110, most people would not take the gamble, because the disutility of losing money is far greater than the utility from gaining, even if the amount to be gained is greater than the potential loss. This defies traditional economic logic where people are perfectly rational and weight events by their probability.

Finally, where people are right now, in the present, matters for any kind of calculation of gain or loss.

To quote Kahneman: “Evaluation is relative to a neutral reference point. [. . .] For financial outcomes, the usual reference point is the status quo. [. . .] Outcomes that are better than the reference points are gains. Below the reference point they are losses. [. . .] When directly compared or weighted against each other, losses loom larger than gains.” (Kahneman 282).

And so Kahneman’s thesis has two main channels, (1) people dislike losses more than they like gains, and (2) the reference point, that is someone’s current status, is really important in assessing the value of a change.

So when people think about their payroll taxes going up in January 2013, their reference point is December 2012, not December 2010, even though they knew the taxes would go up eventually. Furthermore, people always pay more attention to losses than to gains.

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