Behavioral Economics Foils an Obama Tax Cut?

New research finds that a trendy economic theory backfired on the Obama Administration. Or did it?

Illustration by 731; Photograph by Garry Gay/Getty Images

By Drake Bennett

The Making Work Pay tax credit, part of President Barack Obama’s 2009 stimulus bill, was one of the least noticed tax cuts of all time. Rather than coming as a check from the government with the sum written on the dotted line, Making Work Pay—a credit of up to $400, or $800 for couples filing jointly—was disbursed in a steady dribble. The middle-class workers who were its target had their paychecks grow slightly for part of 2009 and 2010, as the government withheld less. When asked, many didn’t realize they’d gotten anything.

Why do it this way? It’s rarely good politics to spend more than $100 billion in public money on something few people notice. But policymakers believed that parceling out the money piecemeal, rather than sending it to taxpayers in a lump sum, had two advantages: It could start sooner, since people didn’t have to wait for the check; and it was more likely to work. By giving people the sense that their incomes had grown, doling out the money paycheck by paycheck was supposed to make recipients more likely to spend it, thereby lifting the economy. That was the theory, anyway, according to a school of thought favored in the Obama White House: behavioral economics.

In the past decade, this new set of ideas about economic behavior has gone from the margins of academia to the intellectual mainstream. In 2002 one of its godfathers, the psychologist Daniel Kahneman, won the Nobel Prize in Economics, and the years since have seen a growing list of best-sellers (Malcolm Gladwell’s Blink, Richard Thaler and Cass Sunstein’s Nudge, Dan Ariely’s Predictably Irrational) describing and drawing on its findings. Unlike neoclassical economists, behavioral economists don’t see people as rational actors coolly weighing costs and benefits. Behaviorists argue instead that people rely on a set of instincts, biases, and cognitive shortcuts to make decisions, which often lead them to choices they come to regret. We save too little and spend too much, we stick with the status quo even when it costs us money, we avoid smart risks and take dumb ones.

In 2009 this theory held obvious appeal to the incoming Administration. If the country’s ills were in part the result of poor financial decisions people made unconsciously, perhaps those problems could be fixed through behaviorally informed public policy. The Administration’s first big legislative push, its stimulus bill, presented an opportunity to test some exciting new ideas on a national scale.

It didn’t work. That, at least, is the finding of the first study to look specifically at the behavioral economics element of the stimulus. In a forthcoming paper, three economists—Claudia Sahm of the Federal Reserve, and Joel Slemrod and Matthew Shapiro of the University of Michigan—found that Making Work Pay didn’t get people to spend more money. In fact, it got them to spend less. The study is a prism through which to view both the efficacy of Obama’s stimulus and whether a set of discoveries about the foibles of human decision-making can be translated into effective government policies.

The foundations for behavioral economic theory were laid by two Israeli psychologists: Kahneman and the late Amos Tversky. One of their best-known studies was a simple survey. They presented people with a scenario: As you enter a theater, you realize you have lost the ticket you bought. Would you pay the $10 for a new one? Fewer than half said they would. Kahneman and Tversky asked another set of people the same question, but with one tweak: Rather than lose the ticket, they lost a $10 bill on the way to the theater. Would they go ahead and buy a ticket? Nearly 90 percent said they would.