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40 3 Behavioral Economics and Public Finance Even with the simplifying assumptions that economics usually makes about how individuals form preferences and make choices—perfect optimization, self-interest, and so on—the rigorous analysis of public policy questions is a challenging endeavor. Frame questions too narrowly, such as by asking whether a particular policy works or not, and the analysis can miss larger issues, such as whether the policy was a good idea to start with. Fail to anticipate the ways that individuals will respond to the incentives that policies create or to anticipate the ways that markets will adjust, and policy design will suffer. And so on. Considering the full implications of policies and the conditions that make them necessary requires a comprehensive analytical approach. Public finance provides such an approach. Public finance begins with a theory of when public policy can be productive, identifying conditions under which unregulated markets lead to inefficient or undesirable outcomes. From that understanding, it develops guidelines for designing policies that address those conditions. The power of modern public finance lies in its ability to identify a core set of economic forces (adverse selection, externalities, and so on) and to use those forces both to ascertain the need for policy responses on a wide array of topics—unemployment, environmental policy, and so on—and to generate those responses. In the standard case, public finance does all of that under the assumption that individuals are perfect optimizers, have unbounded self-control, and, usually, have standard preferences. Behavioral economics finds that those assumptions frequently are a poor match for reality. Moreover, we are beginning to discover that those assumptions fail in ways that matter for policy outcomes. For example, 03-0498-0 ch3.indd 40 1/3/11 3:27 PM behavioral economics and public finance 41 in the well-known case of enrollment in retirement saving plans, behavioral economics has shown how default rules—whether individuals must actively enroll or are automatically enrolled, with the ability to opt out—can have surprisingly substantial effects on participation and saving. The standard approach to public finance—which emphasizes the tax subsidy to such plans as the key incentive for participation—did not suggest such an effect and struggles to explain it. Such findings have raised the possibility that the usual conclusions of public finance, by failing to adopt a behavioral approach, may be missing something about how policy—and the world—works. In this chapter, we outline our framework for integrating insights from behavioral economics into the general public finance approach. What is that approach? The study of public finance casts economists in a role similar to that of medical doctors. Much as doctors work with patients to understand what is wrong when they are sick and how to use medicine to improve their lives, public finance economists work to understand what is wrong with the economy when markets fail and how to use the apparatus of the state to improve social outcomes. Much as the analytical process that a doctor follows progresses from diagnosing a problem to advising judgments on how to proceed to prescribing a course of action, so does the process that a public finance economist follows. Psychology and behavioral economics are like a new technology now available to economists and policymakers. Just as a new medical technology such as advanced imaging techniques can improve the accuracy of diagnoses, change judgment calls, and lead to new prescriptions, so can behavioral economics change the way that public finance treats policy problems at each stage of the analytical process. The new model of behavior introduced by psychology can affect our understanding of how markets do or do not fail. It can change the terms and nature of the trade-offs that policymakers face in setting policy. And it can lead to a new set of tools for achieving policy goals as well as refine our understanding of how the old ones work. Below we expand on the ways in which the standard conclusions of public finance are subject to revision when individuals exhibit behavioral tendencies . We review how and why those conclusions can change when policymakers undertake the following three tasks: —Diagnosing policy problems. The first and fundamental issue in public finance is understanding when and how markets fail to maximize social welfare; traditionally, this occurs when markets fail to generate efficient outcomes due to market failure or when market outcomes are in conflict with other social goals, such as equality. A behavioral approach shows how...

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