Taxes: Real & perceived

June 23, 2009, 1:08 am IST in Figuring It Out | Economy | ET

The nitty-gritty of tax policy is being re-examined in the think-tanks, in the light of new economic insights. A recent paper at the Brookings Institution in the US is about behavioural economics and tax policy design. What’s posited is that behavioural economics-the integration of economics and psychology with the objective of more realistic economic modelling-and the attendant insights are deemed relevant for umpteen practical matters including tax policy. The findings in the behavioural corpus do suggest that the ‘standard’ assumptions of individual behaviour are not really accurate, that economic agents do not usually act rationally and nor are they perfectly self-interested. Also, people do hold ‘inconsistent preferences.’ Policy economists too have increasingly come round to the view that the deviations from standard assumptions of routine economic behaviour do need to be taken into account. The paper shows that factoring in behavioural nuances can mean more effective analysis of taxation policy as regards welfare consequences, on issues of implementation and as an instrumentality generally in governmental budgeting. Consider, for example, the question of tax efficiency or tax incidence. In the standard model, revenue ‘elasticities’ are what really matter for tax design. But a behavioural perspective shows that taxpayer response is less ‘straightforward,’ driven as it is by psychology. And further that the standard assumptions of economic behaviour are so ‘consistently violated’ that they cannot be relied upon as workable modelling assumptions. Additionally, agents seem to deviate from standard behaviour in ‘identifiable’ and ‘predictable’ ways. The paper then goes on to illustrate, for example, how behavioural insights would mean rethinking the concept of tax simplicity. Now standard welfare analysis of taxation does suggest the need to aim for simplicity, as a general rule. The idea is that simplicity in tax design leads to tax efficiency. And it does seem that low tax rates on large bases would be relatively more efficient than taxes characterised by a panoply of exemptions, which would in effect mean smaller bases and correspondingly higher rates. The presumption is that complex tax codes are harder for people to comply with, and costlier for the authorities to administer, or so it would appear. However, with imperfectly rational economic agents-the fundamental insight of the behavioural school-it can longer be simply assumed that taxes are perceived correctly. It follows that individuals will not respond to the tax rate as it is set, but rather how they ‘construe’ it. So it’s quite possible that consumers may fail to perceive complex or obscure taxes, but instead make a connection between the said taxes and the benefits funded via the levies. The paper does cite research which show that certain commodity taxes-especially when it comes to consumption read ‘sales taxes’-are all but ignored by consumers. Also, studies abroad do show that individuals pay less attention to automated toll collections and the like. Or, consider income taxes. There’s little evidence that taxpayers prefer to bunch themselves at kink points in the income-tax schedule. Such behaviour is quite consistent with imperfectly rational taxpayers who more often than not fail to perceive a complex tax code. Further, people are more likely to plan to spend a hypothetical tax cut delivered in several small doses rather than one big reduction. The paper does go on to add that ‘many of the standard drawbacks of tax complexity’ remain valid, and so are eminently avoidable. But the point made is that behavioural insights can lead to more nuanced tax policy making. (Behavioural Economics and Tax Policy, William Congdon, Jeffrey Kling and Sendhil Mullainathan, The Brookings Institution, June, 2009)

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Jaideep Mishra Jaideep Mishra
The author is editorial writer and columnist for The Economic Times.

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