I got an email from Steve Landsburg with the subject line "krugman, me and you." I can't decide whether that counts as the sort of threesome I've always dreamt about...
I get daily emails from The Chronicle of Higher Education newsletter. Today's headline: "Academe Today: Professor Says His University Cares Little About Teaching." I had to stop for a second and confirm that I wasn't in fact reading The Onion.
In my class, I try to introduce a topic and then give my students a discussion question to work through so I can make sure that everyone is catching on. This discussion question relates back to the disposition effect, or the bias towards selling winning stocks and away from losing stocks.
If you need a refresher, you can see the entire behavioral economics playlist here.
Steve Levitt, in addition to gaining fame (at least at an economist level, not a Justin Bieber level) for writing Freakonomics, has made a career teasing cause and effect out of (largely) observational data. (By “observational data,” I mean that he doesn’t explicitly run controlled experiments in a lot of cases and just looks at the world as it transpired naturally instead.) Observational data presents an interesting challenge because people usually make choices in life rather than being guided by randomness. As a result, we often end up with selection bias that makes causal interpretations difficult- for example, we can look at people with and without pets and observe that the people who have pets are happier. (This is hypothetical, but it is in keeping with everything I would like to believe about the world.) This doesn’t mean that pets make people happier, since it could just be the case that people who are already happier also tend to adopt pets. It would be better from a data analysis standpoint if people were just randomly endowed with pets (like when a cat showed up on my doorstep when I was little I suppose), but unfortunately for science purposes we live in a society where people choose whether or not to have pets, and this choice aspect kind of messes things up.
To try to overcome this issue, economists tend to look really hard for sources of randomization- technically known as instrumental variables. In the pet example, whether a stray animal showed up on the doorstep might make a good instrumental variable, at least if the showing up was fairly random and people tended to keep the animals once they showed up. Using some statistical fanciness, we could compare the group of people who had animals show up versus those that didn’t and get a reasonable estimate of the causal effect of pets on happiness.
I know what you’re thinking- this is all nice in theory, but it’s not like we keep good records on stray animal on doorstep prevalence. This is true, and wouldn’t it be nice if we could actively create an instrumental variable- perhaps let a bunch of stray cats loose in a neighborhood and record what happens? (I was going to add a disclaimer to not try this, but it could actually be pretty interesting for research purposes.) How about if we could introduce a source of randomness in the easiest way possible, by flipping a coin?
Little is known about whether people make good choices when facing important decisions. This paper reports on a large-scale randomized field experiment in which research subjects having difficulty making a decision flipped a coin to help determine their choice. For important decisions (e.g. quitting a job or ending a relationship), those who make a change (regardless of the outcome of the coin toss) report being substantially happier two months and six months later. This correlation, however, need not reflect a causal impact. To assess causality, I use the outcome of a coin toss. Individuals who are told by the coin toss to make a change are much more likely to make a change and are happier six months later than those who were told by the coin to maintain the status quo. The results of this paper suggest that people may be excessively cautious when facing life-changing choices.
(Note that you should be able to access the article with most university email addresses, and even some alumni email addresses. Worth trying, at least.)
So let’s think this through…the outcome of a coin flip is random, so people were essentially randomized into “change” and “don’t change” groups. This randomization implies that the two groups are (at least approximately) comparable along other dimensions, leaving the change directive as the only systematic difference between the groups (and therefore the only plausible cause of any observed differences in outcomes). If everyone who was told by the coin to make a change actually did so (and vice versa), Levitt wouldn’t have even had to do anything statistically fancy and could have just compared the average levels of happiness of the two groups. Because not everyone listened to the coin (which I guess is sort of a good thing for the world more generally), he had to do the more fancy version of the math but is still able to find a statistically significant causal effect of change on happiness. Cool, huh? Now go make a change- apparently it’s good for you.
In case you’ve forgotten, the disposition effect is the bias toward selling winning stocks (or other investments I guess) and away from selling losing stocks. In the video below, I start covering one of the seminal empirical papers on the disposition effect and can’t resist fangirling out for a second in the process.
You can see the full behavioral economics playlist here.
But what I’m referring to is slightly less, well, dramatic, for starters. So allow me to describe one of my (admittedly many) pet peeves: When economists teach the concept of comparative advantage and gains from trade, it goes something like “hey, if you can pay somebody $20 an hour to clean your house and get paid $25 an hour at your regular job, you can specialize in your job and outsource your housecleaning and have $5 an hour left over! Everyone is better off!” Sounds great, right?
Well I tried it, and boy am I disappointed.* First off, I explained to my boss that I hired someone to clean my house and therefore I am able to spend 3 more hours per week at work. He seemed pleased with that, so I then reminded him to adjust my salary accordingly, and, well, that’s where things sort of went off the rails. Luckily, I’m a great negotiator, so he eventually came around to meet my demand. I started envisioning what I would do with that $5 an hour efficiency prize (mmmmm, Starbucks vanilla sweet cream cold brew, here I come), but when I looked at my online banking statement the numbers didn’t play out as I had expected- got paid for 3 extra hours of work, paid for 3 hours house cleaning and a grande cold brew ($4 and change IIRC) and I’m worse off than I was before? How is that possible?
Dammit, I forgot about taxes- in fairness, if my econ textbook has taught me anything, it is to ignore tax considerations when doing comparative advantage analyses. Hopefully by now you’ve identified the two logistical points that insert frictions into this specialization and gains from trade thing:
A lot of people don’t actually get paid by the hour (and therefore have either a zero or an unclear marginal wage), and, even when they do, they don’t usually have perfect flexibility over how many hours they work.
Income taxes make it such that it only makes sense to specialize if your after-tax wage is higher than what you would pay to get work done.
The first point, well, that’s one’s pretty hard to address (not everyone can have an Uber driver lifestyle I suppose), but it seems like there should be some benefits to thinking about the tax issue here. If my $25 is taxable income, the government collects tax on my $25 but doesn’t collect tax on me cleaning my own house. (Don’t go getting any ideas, government.) If my house cleaner payments were somehow not taxed, the government would lose revenue on my $20 per hour payment but would collect revenue from the person cleaning my house. Granted, this is probably a bit of a loss for the government, since the house cleaner probably pays a lower tax rate then I do, but the government would probably really like that two people are employed rather than one. (If there is slack in the labor market, it need not be the case that I pulled the house cleaner away from some other job.)
Yeah, so this doesn’t happen, and I am stuck cleaning my own house.** You’ve probably gotten out the world’s smallest violin for me at this point, perhaps because many people find there to be something unseemly about hiring people to do stuff that you don’t want to do, like cleaning the house. Economically, I guess the lack of tax abatement isn’t a huge deal, since if people are paid a fixed salary or don’t have flexibility in hours it’s not the tax issue that’s the main impediment to outsourcing one’s house cleaning on the grounds of economic efficiency anyway.
BUT…let’s pretend for a second that I had used childcare rather than cleaning in the above example. Childcare is an importantly different animal, in large part because did you know that kids exist like 24 hours a day? It’s crazy. (Also, if they’re really small you can’t leave them at home by themselves, which is kind of inconvenient.) Because of this, the tradeoff between work and child care is often more binary than in the house cleaning example- in other words, people are generally deciding between working at all and taking care of their kids, or at least deciding between part-time and full-time employment. Because of this feature, it’s a more logistically reasonable candidate for exploiting gains from trade- for example, a potential worker who could pay $10,000 per year for child care (yeah, I know I’m being optimistic compared to many real cases) could leverage trade as long as she could get a job that pays more than $10,000…after taxes. (Yes, I know her taxes as a single person wouldn’t be high, but if she has a partner her marginal tax rate on the $10,000 could be quite high.)
One obvious potential solution to alleviate inefficiency in this situation would be to make child care tax deductible- as noted above, the impact to the government’s bottom line is likely small due to those who wouldn’t have paid for child care without the deduction. On the down side, the government *would* lose revenue from households who were purchasing child care even though it wasn’t tax deductible. Also, there’s that pesky thing we talked about a couple of days ago where tax deductions don’t help lower income households in the ways that we might expect (not to mention that households only get the money back at tax time, which doesn’t help households with short-term cash flow concerns).
1. The deduction would be “above the line.” That means it would appear before Line 37 on the Form 1040, and therefore the deduction would come out of your income before calculating adjusted gross income. Here’s why it matters where on the form the deduction goes: You can take “above the line” deductions on top of the standard deduction, without itemizing your other deductions. As a result, more taxpayers could take advantage of this deduction, including taxpayers who don’t make enough money to itemize. (Itemizing is generally for people who pay a significant amount of mortgage interest and/or state and local tax.)
2. The deduction would apply against one-half of payroll tax, not just income tax. Clinton and others have pointed out that a new income-tax deduction would be of no value to low-income parents who don’t make enough money to pay income tax. Making the deduction also applicable against the employee-paid half of payroll tax would provide some savings to anybody with labor income. The benefit wouldn’t be huge — it would equal 7.65% of the amount deducted — but that’s not nothing.
The article itself still criticizes the plan on the grounds that higher-income households get a larger discount, which is true, but you guys, this could actually get pretty close to a situation where comparative advantage and gains from trade work in the way that the textbook tells me that they do. Now we just need to have clear objectives and dig into the nerdy details of every other policy in order to satisfy…..HAHAHAHAHAHAHAHA, yeah, I know. I’ll instead direct you to the part where Trump confuses his employees with his hotel guests.
* I’m kidding- I’m not, it’s great (though I have an atypical work situation), but just go with me here.
** Still nope.