Behavioral Economics and Public Policy - A Pragmatic Perspective

Behavioral Economics and Public Policy: A Pragmatic Perspective
Author(s): Raj Chetty

Source: The American Economic Review , MAY 2015, Vol. 105, No. 5, PAPERS AND
PROCEEDINGS OF THE One Hundred Twenty-Seventh Annual Meeting OF THE
AMERICAN ECONOMIC ASSOCIATION (MAY 2015), pp. 1-33
Published by: American Economic Association
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American Economic Review: Papers & Proceedings 2015, 105(5): 1-33
http://dx.doi.org/10.1257/aer.p20151 108
RICHARD T. ELY LECTURE
Behavioral Economics and Public Policy:

A Pragmatic Perspective1
By Raj Chetty*
Starting with Simon (1955), Kahneman of and

each viewpoint in different settings (e.g., List
2004; Levitt and List 2007; DellaVigna 2009).
Tversky (1979), and Thaler (1980), a large body
of research has incorporated insights from psy- In this paper, I approach the debate on
chology - such as loss aversion, present bias,behavioral
and economics from a more pragmatic,
inattention - into economic models.1 Although policy-oriented perspective. Instead of pos-
ing the central research question as "Are the
this subfield of behavioral economics has grown
very rapidly, the neoclassical model remainsassumptions
the of the neoclassical economic
benchmark for most economic applications, model
and valid?," the pragmatic approach starts
from a policy question (for example, "How
the validity of behavioral economics as an alter-
native paradigm continues to be debated. can we increase savings rates?") and incorpo-
The debate about behavioral economics is rates behavioral factors to the extent that they
often framed as a question about the founda- improve empirical predictions and policy deci-
tional assumptions of neoclassical economics. sions.2 This approach follows the widely applied
Are individuals rational? Do they optimize
methodology
in of positive economics advocated
market settings? This debate has proved to by be
Friedman (1953), who argued that it is more
contentious, with compelling arguments inuseful favor to evaluate economic models on the accu-
racy of their empirical predictions than on their
assumptions.3 While Friedman used this reason-
* Harvard University, 226 Littauer Center, Cambridge,
ing to argue in favor of neoclassical models, I
MA 02138, and NBER (e-mail: chetty@fas.harvard.edu).
argue that modern evidence calls for incorpo-
Prepared for the Richard T. Ely Lecture, American Economic
Association, January 3, 2015. A video of the lectureratingis behavioral economics into the analysis of
important economic questions.
available. I thank Saurabh Bhargava, Stefano DellaVigna,
Nathaniel Hendren, Emir Kamenica, Lawrence Katz, David
I classify the implications of behavioral eco-
Laibson, Benjamin Lockwood, Sendhil Mullainathan, Ariel
nomics for public policy into three domains.
Pakes, James Poterba, Matthew Rabin, Josh Schwartzstein,
Andrei Shleifer, and Dmitry Taubinsky for helpfulEach
com-of these domains has a long intellectual
tradition in economics, showing that from a
ments and discussions. I am very grateful to my collabo-
rators John Friedman, Nathaniel Hendren, Lawrence pragmatic
Katz, perspective, behavioral economics
Patrick Kline, Kory Kroft, Soren Leth- Petersen, Adam
represents a natural progression of (rather than
Looney, Torben Nielsen, Tore Olsen, and Emmanuel Saez
for their contributions to the studies discussed in thisa paper.
challenge
to) neoclassical economic methods.
First,
behavioral economics offers new pol-
Augustin Bergeron, Jamie Fogel, Michael George, Nikolaus
icy tools that can be used to influence behavior.
Hildebrand, and Benjamin Scuderi provided outstand-
ing research assistance. This research was funded by the
National Science Foundation.
Ť Go to http://dx.doi.org/10.1257/aer.p20151108 to visit2 1 focus on factors that can be changed through policy,
the article page for additional materials and author disclo-
but much of the analysis in this paper also applies to predict-
sure statement. ing the effects of changes in other exogenous factors, such
as technology.
1 Although the implications of psychology for economics
have been formalized using mathematical models only 3 In ain
widely cited example, Friedman points out that
recent decades, some of these ideas were discussed the quali-
behavior of an expert billiards player may be accurately
tatively by the founders of classical economics themselves,
modeled using complex mathematical formulas even though
including Adam Smith (Ashraf, Camerer, and Loewensteinthe assumption that the player himself knows and applies
2005). these formulas is likely to be incorrect.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
2 AEA PAPERS AND PROCEEDINGS MAY 2015
Insights from psychology year to subsidize retirement offer

saving in 401new(k) to
as changing default options
and IRA accounts (Joint Committee or framin
on Taxation
tives as losses instead 2012). I summarize
of recentgains evidence - showing
that e
set of outcomes that that such subsidies
can have muchbesmallerachieved
effects on
policy. This expansion savings rates thanof the
"nudges" (Thaler policy
and Sunstein se
the transition in2008) the public
such as defaults finance
and automatic enrollment li
from studying linear plans that are commodity
motivated by behavioral models oftaxes
1927) to a much richer passive choice. Theseset new policy
of tools allow us
nonlinea
cies (Mirrlees 1971). to achieve savings rates that may have been unat-
Second, behavioral economics can yield tainable with the tools suggested by neoclassical
better predictions about the effects of existing model. These empirical findings are very valu-
policies. Incorporating behavioral features such able irrespective of the underlying behavioral
as inertia into neoclassical models can yield model, although theory remains essential for
better predictions about the effects of economic extrapolation (e.g., predicting behavior in other
incentives such as retirement savings subsidies settings) and for welfare analysis (e.g., deter-
or income tax policies. Moreover, these behav- mining whether policymakers should be trying
ioral features can help econometricians develop to increase savings rates to begin with).
new counterfactuals (control groups) to identify The second application illustrates that behav-
policy impacts. ioral models can be useful in predicting the
Third, behavioral economics generates new impacts of existing policies even if they do not
welfare implications . Behavioral biases (such produce new policy tools. Here, I focus on the
as inattention or myopia) often generate differ- effects of the Earned Income Tax Credit (EITC) -
ences between welfare from a policymaker's the largest means-tested cash transfer program in
perspective, which depends on an agent's expe-
the United States - on households' labor supply
decisions. The EITC provides subsidies that are
rienced utility (his actual well-being), and the
intended to encourage low-wage individuals to
agent's decision utility (the objective the agent
maximizes when making choices). Accounting work more. I discuss recent evidence showing
for these differences between decision and that individuals living in areas with a high den-
sity of EITC claimants have greater knowledge
experienced utilities improves predictions about
the welfare consequences of policies. The dif-the parameters of the EITC schedule and,
about
ference between the policymaker's and agent's
accordingly, are more responsive to the program.
objectives in behavioral models parallelsThese
non-differences in knowledge across areas pro-
welfarist approaches to optimal policyvide (Sennew counterfactuals to identify the impacts
1985; Kanbur, Pirttilä, and Tuomala 2006) andEITC on labor supply decisions and reveal
of the
the techniques used to identify agents' experi-
that the program has been quite successful in
enced utilities resemble those used in the increasing
long earnings among low-wage individu-
literature on externalities (Pigou 1920). als. These results demonstrate that even if one
I illustrate these implications of behavioral
cannot directly manipulate perceptions of the
economics for public policy using a set of EITC,
appli-accounting for the differences in knowl-
cations drawn from recent research. The edge
appli- across areas is useful in understanding the
cations focus on three major decisions people
effects of the existing incentives.
make over the course of their lives: how much to The first two applications focus on the posi-
save, how much to work, and where to live. Each tive implications of behavioral economics, i.e.,
application is motivated by a policy question predicting the effects of policies on behavior.
that has been studied extensively using neoclas- The third application shows how behavioral
sical models. My objective here is to illustrate models also provide new insights into the wel-
how incorporating insights from behavioral eco- fare consequences and optimal design of poli-
nomics can yield better answers to these long- cies. I illustrate these normative implications by
standing policy questions. considering policies such as housing voucher
In the first application, I show how behavioral subsidies whose goal is to change low-income
economics offers new policy tools to increasefamilies' choice of neighborhoods. Recent
retirement saving. The US federal government empirical studies have shown that some neigh-
currently spends approximately $100 billion per borhoods generate significantly better outcomes

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
VOL. 105 NO. 5 RICHARD T. ELY LECTURE 3
for children yet change dobehavior

not and have
increase welfare if agents
higher h
Both neoclassical suffermodels
from behavioral biasesand model
without distorting
behavioral biases behavior if agents present-bias
(e.g., optimize. Model uncertainty o
information) can explain
can thus provide a new argumentwhy for the usefami
of
move to such neighborhoods, behavioral nudges that is distinct from the but
com- t
generate very different mon rationale of libertarian paternalism (Thaler
policy presc
neoclassical model says
and Sunstein 2003). that there i
to intervene except for
Together, the externalitie
three applications illustrate that
models call for incorporating policies behavioralthat
features intoencour
economic
to move to areas models can have substantial
that will practicalimprove value in
dren's outcomes, answering
such certain policy
as questions.
housing Of course, v
sidies or assistance behavioralinfactors may not be important
finding a in new
all
The optimal policy applications.in The decision
this about whether to
setting d
agents' experienced incorporate utilities
behavioral features into - a model
their
to pay for a better should be treated like other standard mod-
neighborhood in
of behavioral biases. eling decisions, Many such as assumptions
economi about
to follow the policy time- separable utility or price-taking behavior
recommendatio
ioral models because by firms. In some of concerns
applications, a simpler model
nalism, i.e., giving may yield sufficiently accurate predictions; pe
policymakers' in
an individual's others, experienced
it may be useful to incorporate utilitybehav-
over the individual's own choices. I discuss ioral factors, just like it may be useful to allow
three nonpaternalistic methods of identifyingfor time nonseparable utility functions. This
pragmatic, application-specific approach to
experienced utilities that have been developed
in recent research: (i) directly measuringbehavioral
expe- economics may ultimately be more
productive than attempting to resolve whether
rienced utility based on self-reported happiness,
the assumptions of neoclassical or behavioral
(ii) using revealed preference in an environ-
ment where agents are known to make choices
models are correct at a general level.4
that maximize their experienced utilities, and
This paper builds on several related literatures.
(iii) building a structural model of the differ-
The applications discussed here are a small subset
ence between decision and experiencedofutili-
a much broader literature that takes a pragmatic
ties. These methods can provide more accurate approach to behavioral economics and public
and robust prescriptions for optimal policy policy.
than Thaler and Sunstein (2008); Congdon,
those obtained from neoclassical models, Kling,ulti- and Mullainathan (2011); Keller- Allen
mately increasing social welfare if individualsand Li (2013); and Madrian (2014) provide
suffer from behavioral biases. examples of the new policy tools and predictions
In some situations - including the neighbor- generated by behavioral economics. Bernheim
hood choice application - one may have to make (2009) and Mullainathan, Schwartzstein, and
judgments about optimal policy without being Congdon (2012) provide further discussion of
certain about whether the currently available
data are generated by a neoclassical or behav-
ioral model. Economists are inclined to use the 4 The relevance of behavioral economics is applica-
tion-specific because deviations from rationality vary widely
neoclassical model as the default option when
across settings. In some markets, behavioral phenomena can
faced with such model uncertainty. A more prin-
be diminished by experience effects, arbitrage, or aggrega-
cipled approach is to explicitly account for model
tion that cancels out idiosyncratic mistakes (see, e.g., List
2004; Färber 2014). But the rarity of important decisions
uncertainty when solving for the optimal policy,
(e.g., buying a house or choosing where to go to college),
as in the literature on robust control (Hansen and
limits to arbitrage (Shleifer and Vishny 1997), and the lack
Sargent 2007). Using some simple examples,
ofIreturns to debiasing consumers (Gabaix and Laibson
show that model uncertainty does not neces-
2006) may lead behavioral anomalies to persist in other set-
sarily justify using the neoclassical model for
tings. This context-dependence makes it difficult to answer
the question of whether individuals are "rational" or not at a
welfare analysis. On the contrary, the optimal
general level. The pragmatic approach discussed here deals
policy in the presence of model uncertainty may
with these issues of external validity and generalizability by
be to use behavioral nudges (such as changes directly
in focusing on the relevance of behavioral economics
defaults or framing), because such nudges can for the question of interest.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
normative issues in behavioral models. All of

such as labor supply or neighborhood character-
these applications of behavioral economics build
istics. Let p denote the pretax price vector for the
directly on prior research translating lessons
c goods and Z the individual's wealth.
from psychology to economics and documenting Following Kahneman, Wakker, and Sarin
(1997), let u(c) denote the agent's experienced
empirical evidence of deviations from neoclassi-
cal models. Conlisk (1996), Rabin (1998); utility
and - his actual well-being as a function of
choices - and v(c) his decision utility - the
DellaVigna (2009) provide an excellent over-
view of this earlier body of work. objective he seeks to maximize when choosing c .
Finally, the empirical applications discussed As discussed by DellaVigna (2009), in a setting
without
in this article are all examples of recent studies in uncertainty, the agent's decision utility
applied microeconomics that use administrative can differ from neoclassical specifications either
datasets with millions of observations. Thisbecause
big he has nonstandard preferences - e.g.,
data approach often leads researchers to identifya utility function that exhibits reference depen-
dence - or because he is influenced by ancillary
empirical regularities that are unrelated to their
initial hypotheses and sometimes do not match conditions (Bernheim and Rangel 2009), such as
neoclassical predictions, making it usefulthe toway in which choices are framed. The ancil-
draw on insights from behavioral economics.lary As conditions do not enter the agent's expe-
economics becomes an increasingly empirical rienced utility and budget set, and hence have
science, economic theories will be shaped more no effect on behavior in a neoclassical model.
directly by evidence, and the pragmatic approach It is useful to divide the ancillary conditions
to behavioral economics described here may into two groups: those that can be manipulated
become even more prevalent and useful.5 by policymakers (such as defaults), which I
The paper is organized as follows. Section I "nudges" n following Thaler and Sunstein
label
formalizes the three pragmatic implications(2008), of and a set of other ancillary conditions
behavioral economics for public policy using d that may affect agent behavior but cannot be
a stylized model. Section II discusses the new manipulated through policy, such as perceptions
policy tools offered by behavioral economics,or overconfidence.
The planner's objective is to choose a set
focusing on retirement savings. Section III illus-
trates how behavioral models can help us bet-of tax rates t and nudges n that maximize the
agent's experienced utility u(c) subject to a
ter predict the effects of income taxes and labor
revenue requirement R and a standard incen-
supply. Section IV discusses the welfare impli-
cations of behavioral economics in the con- tive-compatibility condition for the agent:6
text of neighborhood choice. Each section also
(1) max, „ u(c) s.t.
briefly reviews other applications that illustrate
the implications of behavioral models for other
(2) t-c = Ř
questions. I conclude in Section V by discussing
some lessons for future research.
(3) c = arg maxc{v(c|tt,¿/) s.t
I. Conceptual Framework
Neoclassical economics solves
This section formalizes the implications of of this general optimal policy
behavioral economics for public policy using a typically imposes the following
simple representative-agent model. Let c denote a straints on (l).7
vector of choices made by the agent. In canonical
examples, c represents a set of different consump-
6 The assumption that policymakers
tion goods or consumption at different times, but
individuals' experienced utilities has bee
one can also interpret c as including other choicesmark in normative economics since Bentham's formulation
of utilitarianism, but many other objectives have also been
proposed (e.g., Sen 1985). See Kahneman and Sugden
5Hamermesh (2013) documents the increasing influence (2005) for a discussion of whether maximizing experienced
of empirical evidence in economics by studying publication utility is a reasonable criterion in behavioral models.
patterns. He reports that the fraction of empirical articles The definition of a "neoclassical" model varies across
published in general interest economics journals increasedpapers. A minimal requirement is that choices satisfy consis-
from 38 percent to 72 percent between 1980 and 2010. tency and transitivity, but most applied economists impose

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
ASSUMPTION or1 changes(Neoclassical

in information provision is as ad hoc Re
The planner does not
an assumption have
as restricting attentionany
to linear policy
the agent's decision taxes or limiting attention to taxes onis
utility a subseta smoot
ing, , and concave function
of goods in the economy. Although any of these of co
choices , and experienced assumptions may be useful simplifications
utility to equ
utility : make progress in a given application, there is no
deep justification for giving priority to models
(4) n = 0 that restrict the policy set. For example, consider
the well-known result that linear consumption
(5) d = 0, v(c) smooth, increasing,
taxes become superfluous once one permits non-
and concave linear income taxation under fairly general con-
ditions (Atkinson and Stiglitz 1976). This result
(6) u - v. prompted researchers to reevaluate the rationale
for taxes on capital income and commodities in
Mirrlees'as
Behavioral economics can be interpreted s framework rather than continue to
relaxing the constraints in (4), (5), and
work (6).
in Ramsey's framework. Similarly, if one
There is a long methodological tradition
were to of
find that changes in default provisions in
relaxing such constraints in economics,retirement
and in savings plans obviate the need for tax
this sense behavioral economics represents
subsidies,ait would be difficult to justify retain-
natural progression of widely accepted methods
ing the assumption in (4) when studying optimal
savings
in the economics literature. I consider the impli-policies.
Relaxing (5) yields better predictions about
cations of relaxing each of the three constraints
in turn.8 the effects of existing policies. A model of deci-
Relaxing (4) yields new policy tools. For sion utility that incorporates nonstandard prefer-
example, policymakers may be able to influence ences and ancillary conditions can be helpful in
the agent's choice of c by making certain features predicting the effects of taxes (dcj/dtļ) regard-
of the choice set more salient or changing default less of whether it offers new tools to manipulate
options. Expanding the policy set broadens the behavior (n= </>). Building models of behavior
set of feasible allocations that can be achieved, whose predictions more accurately match data
which could ultimately increase welfare u(c). is a core focus of positive economics. As one
This expansion of the policy set parallels the example, consider recent evidence that the drop
shift from studying linear taxes on commod- in expenditure around retirement may be better
ities (Ramsey 1927) to a mechanism design explained by a model that features complemen-
approach that permits general, nonlinear taxes tarities between consumption and labor in the
(Mirrlees 1971). 9 Ruling out the use of defaults utility function (Aguiar and Hurst 2005). Few
would insist on retaining the assumption of sep-
arable utility when studying consumption pat-
stronger additional assumptions, such as smoothness of
utility and concavity (which rule out phenomena such as ref-terns around retirement in light of such evidence.
erence points) or exponential discounting (to rule out time Similarly, if one can better explain the data in a
inconsistent choices). The precise delineation between "neo-relevant application by incorporating features
classical" and "behavioral" models is a matter of terminol-
such as inattention or reference dependence into
ogy and is not central for the main arguments in this paper,
which focus on the implications of relaxing the restrictionsthe model of individual decisions v(c 'n,d ) , there
made in existing models. would be little justification for excluding these
Assumption (6) subsumes assumption (4); hence, drop- factors. Importantly, these modeling decisions
ping (4) requires dropping (6) as well. If decision utility
are application-specific: for some applications
coincides with experienced utility, policy nudges (which
(e.g., understanding the effects of income taxes
by definition do not enter experienced utility) cannot affect
on
behavior. I write (4) as a separate assumption to distinguish labor supply), a model featuring separable
violations of (6) that yield new policy tools n from those
that do not.
y Ramsey (1927) solved (1) subject to (2)- (6) as well requirement,
as since this leaves behavior undistorted. Mirrlees
the additional condition that not all goods can be taxed. If expanded the set of policy tools under consideration
(1971)
all goods can be taxed, the problem is trivial: the optimal
by allowing for nonlinear taxes on income, and subsequent
policy is to impose what is effectively a lump-sum work
tax in the mechanism design literature allows for a general
by taxing all goods at the same rate to meet the revenue
set of taxes on consumption and income.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
this reasonperfectly
utility might yield (e.g., Mullainathan, Schwartzstein,
reasona
tions, and most economists
and Congdon 2012). Measuring the would
internal - not
allowing for complementarity
ity e(c) requires identifying the impact of an bet
sumption and labor
agent's choice
inon hissuch
own experienced
cases.
utility, Ap
same approach much asbehavioral
to measuring a traditional externality
econom
call for requires identifying
incorporating the impact of
only an agent'sbeha
the
ments that are essential
choices on other agents' experienced
for utilities.10
obtainin
Correspondingly,
predictions for the recent research has developed
application at han
Thus far, I have focused
various methods on e(c)the
of estimating internalities
implications of behavioral economics, as that resemble those used in the literature on
in Friedman (1953). Relaxing (4)-(6) also externalities, which are discussed in Section IV
yields new welfare implications. If agents below.
have nonstandard experienced utilities, such as The pragmatic value of behavioral econom-
reference-dependent preferences, then the wel- ics - new policy tools, better predictions of the
fare consequences of policies naturally differ effects of existing policies, and new welfare
from the predictions one would obtain from a implications - can ultimately be evaluated only
neoclassical model. However, as long as the in the context of real-world applications. The
decision and experienced utility are identical next three sections of the paper illustrate these
(i.e., (6) holds), one can still conduct welfare ideas more concretely in the context of such
analysis using revealed preference methods applications.
analogous to those in the neoclassical model
because an agent's observed choices reveal his II. New Policy Tools: Increasing Retirement
experienced utility u(c) . Savings
Welfare analysis in behavioral models
becomes more challenging when experienced In this section, I illustrate the ways in which
and decision utilities differ, as is the case when
behavioral economics can expand the set of pol-
agents suffer from behavioral biases such as icy tools available to policymakers. The central
inattention or present bias. Since the plan- application that I focus on is increasing retire-
ner's objective is no longer directly related to ment savings, an area where behavioral eco-
the agent's decision utility, one cannot use the nomics has already had a significant impact on
agent's observed choices to recover the welfare policy (Madrian 2014). I begin by summarizing
function u(c). As discussed by Kanbur, Pirttilä, recent evidence on the impacts of neoclassical
and Tuomala (2006), this problem is formally tools (i), namely, tax subsidies for retirement
analogous to nonwelfarist approaches to optimal saving, and then discuss new policy tools
policy, in which the planner's objective differs (n) - defaults and automatic enrollment plans -
from maximizing the agent's private utility. For that emerge from behavioral models. In the
example, Sen (1985) discusses social welfare final subsection, I briefly review other examples
functions that incorporate notions of individ- of policy tools that have emerged from behav-
uals' capabilities and freedoms in addition to ioral models, such as information provision to
their hedonic utilities, while Besley and Coate increase college enrollment rates and loss fram-
(1992) model the planner's objective as a func- ing to increase the impacts of incentive pay for
tion of income levels rather than utility. teachers.
The problem of measuring social welfare
when experienced and decision utilities differ
bears many similarities to the classic problem
10 One conceptual difference between externalities and
of measuring social welfare in the presence of
internalities is that other agents' utilities are exogenously
externalities (Pigou 1920). This can be easily affected by the actions of a given agent in the case of exter-
seen by writing the planner's objective in ( 1 ) nalities. With internalities, the agent makes the choice in
as v(c) + e(c) where e(c) = u(c) - v(c) mea- question herself, and hence the planner arguably needs
a stronger rationale to intervene and overrule the agent's
sures the "externality" that the agent imposes
endogenous decision. That is, the very fact that an agent her-
on himself by making suboptimal choices. The self made a choice c increases the probability that the choice
term e(c) is frequently labeled an ' internality" might have been optimal and thus raises the bar for policies
in the behavioral public economics literature for that seek to change c.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
A. Neoclassical Tools : Subsidies shown in panel A of Figure 1 , which plots mean

for Retirement Saving capital pension contributions versus taxable
income. The figure is constructed by grouping
individuals into DKr 5,000 income bins based
There is growing concern that many people
on their current taxable income relative to the
may not be saving adequately for retirement
(e.g., Poterba 2014), and policymakers tophave tax cutoff, demarcated by the dashed vertical
expressed interest in increasing householdline.
sav-It then plots the mean capital pension con-
ings rates. What is the best way to achievetribution
this in each bin in each year from 1996 to
goal? 2001 versus income. The relationship between
The traditional approach to increasing retire- income and capital pension contributions is
ment savings is to subsidize saving in retirement stable from 1996 to 1998, the years before the
accounts (changing t in the model in Section I). reform. In 1999, the marginal propensity to save
The United States federal government spends in capital pension accounts falls sharply for
more than $100 billion per year on subsidies for those in the top bracket: each DKr of additional
retirement savings accounts such as 401 (k) s and income leads to a smaller increase in capital
IRAs by granting saving in these accounts favor- pension contributions. The changes are substan-
able tax treatment (Joint Committee on Taxation tial: mean capital pension contributions fell by
2012). A large empirical literature has evaluated nearly 50 percent for individuals with income
the effects of these subsidies on savings rates 25,000-75,000 DKr above the top income tax
by testing predictions derived from neoclassical cutoff.
life-cycle models. This work has obtained mixed The aggregate patterns in panel A of Figure 1
results (Poterba, Venti, and Wise 1996; Engen, appear to support the predictions of neoclassical
Gale, and Scholz 1996) because of limitations life-cycle models of savings behavior: reducing
in data availability and because the neoclassical the subsidy for saving in a particular account
model does not predict observed savings pat- reduces contributions to that account. However,
terns well, as I discuss below. the individual-level responses underlying these
In a recent study, Chetty et al. (2014a) use aggregate patterns point in a different direc-
41 million observations on the savings of all tion. Panel B of Figure 1 plots the distribution
Danish citizens from 1995-2009 to present new of changes to individual capital pension contri-
evidence on the effects of subsidies on savings butions (as a fraction of lagged contributions)
behavior. I focus on this study here because it for individuals who were contributing to capital
illustrates the value of incorporating behavioral pensions in the prior year. The sample in this fig-
economics into the analysis of canonical policy ure consists of individuals whose incomes place
questions. them 25,000-75,000 above the top tax cutoff,
The Danish pension system is similar to that the "treatment" group affected by the subsidy
in the United States, except that Denmark has reduction.11 The figure plots the distribution
two types of tax-deferred savings accounts: cap- of changes in contributions for this group from
ital pensions that are paid out as a lump sum 1998 to 1999 (the year of the treatment) and
upon retirement and annuity pensions that are from 1997 to 1998 as a counterfactual.
paid out as annuities. In 1999, the Danish gov- Panel B of Figure 1 shows that many of the
ernment reduced the tax deduction for contribut- individuals in the top tax bracket leave their cap-
ing to capital pension accounts from 59 cents per ital pension contributions literally unchanged
Danish Kroner (DKr) to 45 cents per DKr for in 1999 despite the fact that the capital pension
individuals in the top income tax bracket. The subsidy was reduced. Since any optimizing agent
cutoff for the top tax bracket was DKr 251,200
(US $38,600) in 1998, roughly the eightieth per-
centile of the income distribution. The deduction
1 1 The treatment group is defined starting with individuals
was unchanged for those in lower tax brackets, DKr 25,000 above the top tax cutoff (rather than exactly at
and the tax treatment of annuity pension contri-the top tax cutoff itself) because individuals face uncertainty
butions was also unchanged. in their taxable income when making retirement account
contributions during the year. Since individuals close to the
Chetty et al. (2014a) begin by analyzing the cutoff might not have expected to be in the top bracket at
impacts of this reform on mean capital pension the end of the year, including them could understate the true
contributions. The results of this analysis are response to the subsidy change.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
not describe the behavior of all the individuals

in the economy.12 Moreover, a large fraction of
individuals stop contributing to capital pensions
entirely, as shown by the spike in the distribution
at -100 percent in 1999. Chetty et al. (2014a)
show that the entire aggregate reduction in cap-
ital pension contributions shown in panel A of
Figure 1 is driven by the additional 19.3 percent
of individuals who stopped contributing to cap-
ital pensions when the subsidy was reduced in
1999. The remaining 80.7 percent of the popula-
tion appear to have made no change in their sav-
ings plans in response to the change in subsidies,
again contradicting the predictions of the neo-
classical model. Hence, 80.7 percent of individ-
uals are "passive savers" who are unresponsive
to changes in marginal incentives, while 19.3
percent are "active savers" who behave as the
neoclassical model would predict.
Next, Chetty et al. (2014a) assess whether the
19.3 percent of individuals who stopped contrib-
uting to capital pension accounts reduced their
total amount of saving or shifted this money to
other accounts. They find that roughly one-half
of the reduction in capital pension contributions
was offset by increased contributions to annu-
ity pension accounts and the rest was almost
entirely offset by increased saving in taxable
accounts (e.g., bank and brokerage accounts).
Based on this analysis, they conclude that each
$1 of tax expenditure on retirement savings sub-
sidies increases retirement saving by approx-
imately $0.01, with an upper bound on the 95
Figure 1. Effects of Reduction in Subsidy for percent confidence interval of $0.10.
Retirement Savings Accounts in Denmark There are two lessons of this analysis from
the perspective of behavioral public economics.
Notes: This figure reproduces Figures Va and VIb in Chetty
First, responses that appear to be consistent with
et al. (2014a). Panel A plots mean total (individual plus
employer) capital pension contributions for individuals with
optimization in the aggregate may mask signifi-
income in each DKr 5,000 income bin within DKr 75,000 cant deviations from optimization at the individ-
of the top income tax threshold, in each year from 1996 to ual level. Second, the standard tools suggested
2001. Panel B plots the distribution of changes to individual by neoclassical models are not very successful
capital pension contributions, as a percentage of lagged indi-
(at least in some settings) in increasing savings
vidual pension contributions, for individuals who are DKr
$25,000-$75,000 above the top tax cutoff in 1998 and 1999 rates because they appear to induce only a small
(the treatment group affected by the subsidy reduction). group of financially sophisticated individuals
Panel B restricts the sample to individuals who were con- to respond, and these individuals simply shift
tributing to capital pension accounts in the previous year. assets between accounts. These results natu-
rally lead to the question of whether other policy
tools - perhaps those that directly target passive
at an interior optimum should change capital

12 A neoclassical life-cycle model can generate zero
pension contributions by some nonzero amount response if wealth and price effects happen to offset each
when the subsidy is reduced, this fact immedi- other exactly. However, this is a knife-edge (measure zero)
ately implies that the neoclassical model does case.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
savers - can be more effective in i

saving.
B. New Policy Tools : Defaults and Automatic

Enrollment
A large body of research over the past

decade has found that employer defaults have
a large impact on contributions to retirement
accounts despite leaving individuals' incentives
unchanged. In an influential paper, Madrian and
Shea (2001) show that an opt-out system - in
which employees are automatically enrolled into Figure 2. Effects of Employer Contributions to
Retirement Accounts
their company's 401 (k) plan but are given the
option to stop contributing - increases participa-
Notes: This figure reproduces Figure lb in Chetty et al.
tion rates in 401(k) plans from 20 percent to 80 (2014a). The figure analyzes a set of workers who switched
percent at the point of hire. This result has since to a new firm whose employer pension contribution rate was
been replicated in numerous other settings (e.g., at least 3 percentage points of labor income higher than their
Choi et al. 2002). Similarly, Thaler and Benartzi previous firm. The ;t-axis of the figure is the calendar year
relative to the year the worker switched firms, so that year 0
(2004) show that individuals who enroll in plans represents the first year the worker is employed at the new
to escalate retirement contributions over time
firm. The figure plots mean employer and individual retire-
rarely opt out of these arrangements in subse- ment account contributions as well as individuals' taxable
quent years. savings in each year, all measured as a percentage of cur-

rent labor income. The sample consists of workers for whom
While defaults clearly have substantial effects
data is available for event years [-4, +4], so that the number
on contributions to retirement accounts, it is crit-
of observations is constant through the figure. The sample
ical to determine whether these larger retirement also includes only workers with positive individual pension
contributions come at the expense of less saving contributions prior to the switch, i.e., those who are able to
in non-retirement accounts or actually induce reduce individual pension contributions when employer con-
tributions rise. The figure lists the change in each form of
individuals to consume less (as required to raise savings (as a percentage of labor income) from year - 1 to
total savings rates). Most studies to date have year 0.
not been able to estimate such crowd-out effects
because they do not have data on individuals'
full portfolios. Chetty et al. (2014a) are able to fully offset changes in employer contributions in
resolve this problem because the Danish datathis manner.
they use contain information on savings in all Chetty et al. (2014a) test this prediction and
accounts. They study the impacts of defaults on estimate the causal effect of employer pension
total savings by exploiting variation in employ- contributions on savings rates using an event-
ers' contributions to retirement accounts across study research design, tracking individuals
firms. In Denmark, employers and individuals who switch firms. This design is illustrated in
contribute to the same accounts, so changesFigure 2, which plots the savings rates of indi-
in employer contributions are analogous toviduals who move to a firm that contributes at
changes in defaults. Consider an individualleast 3 percentage points more of labor income
who is contributing DKr 2,000 to his retirement to their retirement accounts than their previous
account. Suppose his employer decides to take firm. Let year 0 denote the year in which an indi-
DKr 1 ,000 out of his pay check and contribute vidual switches firms and define event time rel-
it to his retirement account, so the individual'sative to that year (e.g., if the individual switches
total compensation stays fixed. Since the indi- firms in 2001, year 1998 is -3 and year 2003
vidual could fully offset this change by reduc-is +2). The sample consists of individuals who
ing his personal contribution to DKr 1,000, theare observed for at least four years both before
employer contribution effectively changes theand after the year of the firm switch (to obtain a
"default" contribution rate without changing the balanced panel) and who make positive individ-
individual's budget set. Indeed, the neoclassicalual pension contributions in the year before they
life-cycle model predicts that individuals shouldswitch firms (to limit the sample to individuals

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
who are able to levels of wealth, and

offset the are more likely to have
increase i
contributions). taken finance courses in college. Hence, defaults
The series in squares
not only have a larger in Figure
impact on aggregate sav-2 p
employer contributions
ing, but also target those (towho are capital
saving the least an
accounts). By construction,
for retirement more effectively than employ
existing
butions jump in priceyear
subsidies. 0, by an aver
percent of labor The broader lesson of this work
income for is that defaults
individu
make it feasible
sample. The series in triangles to achieve outcomes that cannot
plots t
ual's own pension contributions.
be achieved with subsidies. Given an exogenous Indi
sion contributionspolicy fall
objective of by increasing0.56
saving, thispercen
empir-
from year - 1 to ical
yearfinding has0, far
practical value even less than t
if the under-
lying behavioral assumptions remain
in employer contributions. debated.14
Finally, th
circles in Figure Indeed,
2 plots savings
in light of the work by Madrian and Shea in all
able accounts. Savings
(2001) and Thaler and in Benartzitaxable
(2004), defaults ac
essentially unchanged
have already started around
to be systematicallythe applied poi
firm switch. Theseto increase retirement savings by both
findings show private tha
companies and
in employer pension governments.
contributions are
significantly by Although
lessthe saving
empirical findingsin other
on defaults
that is, employer defaults
have great value, understandingeffectivel
the theory that
explains savings on
total saving. Building behaviorevent
remains useful studi for
form, Chetty et al. The
two reasons. (2014a)
first is extrapolation: estimat
predict-
ing the impacts
increase in employer of defaults in other contextsacco
retirement
(e.g., larger changes
butions coupled with a $1 in default rates) requires
reduction i
a theory of saving that is
that total compensation explains why defaults
unchanged
individuals' net savings
matter, such as the model rate by pro-
of procrastination appr
posed by Carroll
$0.85. These savings et al. (2009). Second, persist
increases welfare
than a decade and analysis
lead requires to a modelgreater
of savings behavior. wea
at retirement, showing that
Should we be trying to increase employ
the amount peo-
have long-lasting effects
ple save for retirement? If on so, what is savings
the optimal b
Since the neoclassical
default savings rate? These model
optimal policy ques- pred
offset of changes tions in
cannot beemployer
answered without specifying defaul
the
that a $1 increaseunderlying
in behavioral
defaults model. I returnraises
to these to
by $0.85 implies normative
that questions
85 in Section
percent IV. of i
are "passive savers" From awho methodological are perspective,
inattenti the
retirement plans research
and on retirement
simply savings overfollowthe past
decade captures the essence
option.13 This estimate of the pragmatic
is consistent
finding discussed approachabove that
to behavioral economics. Much ofrough
the
cent of agents research
respond in this literature haspassively
been motivated by
in subsidies. The finding15-20
the most effective percent
way to increase sav- of
who respond actively
ings rates rather thanto testing price
the assumptions ince
also much more of neoclassical models.
likely toFor example, Chetty emp
offset
sion contributionset al. (2014a)
by did reducing
not set out to test whether savin
accounts. These active savers tend to be more
agents optimize in making savings decisions;
financially sophisticated (e.g., they rebalance
their portfolios more frequently), have higher
14 For example, the evidence on defaults could be
explained by a model with inattentive agents or a signaling
model in which individuals who are uncertain about how
13 Crowd-out could be less than 100 percent even in much the they should save treat the default as an informative
neoclassical model if individuals hit the corner of 0 individ- signal about the correct savings rate. Distinguishing between
ual pension contributions. Chetty et al. (2014a) show that these "behavioral" and "rational" models is only useful if the
this effect accounts for very little of the imperfect crowd- two models generate different predictions in some domains;
out that is observed because even individuals who are well from a pragmatic perspective, there is no inherent advantage
within the interior do not offset most of the changes to in
the "rational" signaling model if it does not provide better
employer contributions. predictions.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
VOL. 105 NO. 5 RICHARD T. ELY LECTURE 1 1
instead, the goal of

cantly the
increases study
the probability was
that their chil- t
the effectiveness
drenof
attend alternative polic
college. Similarly, Hoxby and Turner
retirement saving, with
(2014) show anhigh-achieving
that providing initial stu- fo
subsidies (t). Indents
the process
from low-income of
families with stu
simple
data, it became evident
information about the that individu
college application pro-
ior was better explained
cess and colleges' net costs
by given
behaviora
their families'
that generate passive choice.
particular financial This
situation increases nat
the prob-
abilityof
to the exploration that children
new applypolicy
to and attend more
tool
selective colleges.
as employer defaults. The interventions imple-
Although one c
approached this policy
mented in both ofquestion from
these studies are inexpensive;
neoclassical perspective - focusing
for instance, the intervention implemented by e
on the impacts ofHoxby and Turner (2014)
price cost $6 per student.
subsidies - th
sis of new policy tools
Information motivated
and application by
assistance thus pro-
vide new tools
models yields richer to raise college attendance
insights and rates ultim
that may be much more
ter methods of increasing cost-effective at the
retirement
margin than existing policy tools, such as grants
or loans.
C. Other Applications
Loss-Framing and Teacher Performance. -
In this section, IFryer et al. (2012) showsummarize
briefly that framing teacher f
applications in which incentives as losses relative to a higherfrom
insights salary b
economics have been used
rather than bonuses to
given for develop
good performance
icy tools.15 increases the impact of these incentives on stu-
dent performance. In particular, teachers who
Simplification and Choice of Health Plans. - are given bonuses in advance and told that the
Bhargava, Loewenstein, and Sydnor (2014) money will be taken back if their students do
study a large US firm where employees choose not improve sufficiently generate significantly
from a menu of health insurance plans that vary higher student test scores than those paid a con-
in several dimensions (e.g., deductibles, copay ventional performance bonus. Such loss-framing
rates, out-of-pockeť maximums, etc.). They has no additional fiscal cost to the government
show that many individuals choose strictly dom- and thus provides an attractive new policy tool
inated health insurance plans, i.e., plans that to improve students' outcomes.
reduce their payoffs in all states of the world.
Their findings imply that simplifying the set Social Comparisons and Energy
of options given to individuals can potentially Conservation. - Allcott (2011) shows that
improve their decisions. Interestingly, Bhargava, sending households a letter informing them
Loewenstein, and Sydnor (2014) find that sub- about their energy usage relative to that of their
optimal choices are particularly common among neighbors reduces mean energy consumption
low-income households, suggesting that com- This finding is consistent with models of social
plexity may have negative distributional conse- comparisons in which individuals are concerned
quences in addition to reducing average welfare. about how their behavior compares with others'
behavior. Such social comparisons are now com-
Application Assistance and College monly used by utility companies alongside con-
Attendance. - Bettinger et al. (2012) show that ventional policy tools such as price increases.
offering information and assistance in complet- All of these studies exemplify the pragmatic
ing the Free Application for Federal Student approach
Aid to behavioral economics: their goal
(FAFSA) form to low-income families signifi- is to evaluate the efficacy of new policy tools
suggested by behavioral models rather than
test-specific assumptions of neoclassical or
behavioral models. In some cases, it is not even
15 Perhaps the most concrete evidence that behavioral
economics has expanded the set of policy tools available to
fully clear exactly what the underlying behav-
policymakers is the creation of "nudge units" in the US and
UK governments that are tasked with formulating and testing
ioral model is. For instance, application assis-
tance could matter because individuals exhibit
new policies that do not involve direct changes in financial
inertia,
incentives, such as defaults, framing, and social persuasion. lack information, or procrastinate in

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
filling out forms.EITC

Similarly,
amounts depend upon athere
tax filer's tax-are
able income,
potential theories marital status, and number mode
- "rational" of chil-
on signaling effects
dren. Panel Aand
of Figure 3"behavioral
plots EITC amounts as
based on relative comparison
a function of taxable income for singleutiliti
tax filers
could explain tastes with for
1 versus 2conformity
or more children, expressedin in e
consumption. Despite real 2010 dollars.
this EITC refund amounts first
uncertainty a
underlying assumptions, the(the
increase linearly with earnings new"phase-in"pol
identified as a result region), then
of areincorporating
constant over a short income b
considerations have pragmatic
range (the "plateau"), and are thenvalue
reduced lin- in
ing the set of outcomes early (the "phase-out" that region). The phase-in
policyma
achieve.16 subsidy rate is 34 percent for taxpayers with 1
child and 40 percent for those with 2 or more
III. Better Predictions: Effects of Income Taxes children; the corresponding phase-out tax rates
on Labor Supply are 16 percent and 21 percent. Because individ-
uals face payroll and other taxes, they obtain the
Even if they do not generate new policy tools, largest tax refund when their taxable income
behavioral models can still be useful in predict- exactly equals the first kink of the EITC sched-
ing the impacts of existing policies. This ule, sec-which is $8,970 for filers with 1 child and
tion demonstrates this point by showing that$12,590 the for those with 2 or more children.17
effects of the Earned Income Tax Credit (EITC) One of the primary goals of the EITC is to
on labor supply decisions are better predictedincrease
by the labor supply of low-wage work-
a model that allows for imperfect knowledge ers
ofby increasing their effective wage rates. A
large literature has evaluated whether the EITC
the tax code, an ancillary condition (d) that plays
no role in neoclassical models of labor supply.
is effective in achieving this goal by estimating
I begin by discussing recent evidence which
labor supply elasticities in neoclassical mod-
shows how differences in knowledge about els
theof labor supply. This work has found clear
EITC across areas lead to spatial variation in
evidence that the EITC increases labor force
its impacts on reported taxable income. I thenparticipation, but mixed evidence on the effects
turn to the program's impacts on real labor ofsup-the EITC on hours of work and earnings con-
ditional on working (Eissa and Hoynes 2006;
ply decisions. In the final subsection, I discuss
experiments that evaluate whether information Meyer 2010).
provision can be used as a new policy tool Chetty,
to Friedman, and Saez (2013) - hence-
increase the impacts of the EITC. forth, CFS - study the impacts of the EITC
using new data from de-identified federal
A. Effects of the Earned Income Tax Creditincome
on tax returns covering the US population
Reported Income from 1996-2009. These administrative data per-
mit a much more precise analysis of the EITC's
The EITC is the largest means-tested cash
impacts because they are several orders of
transfer program in the United States. In 2012,
magnitude larger than the survey dataseis used
27.8 million tax filers received over $63 billion
in prior research. CFS 's core analysis sample
in federal EITC payments (Internal Revenue
includes 78 million taxpayers and 1.1 billion
Service 2012, Table 2.5). The federal EITC
observations on income.
was expanded to its current form in 1996, and CFS 's initial research plan - which had
remained essentially unchanged over the next no 15
connection to behavioral models - was to
years aside from inflation indexation. exploit state-level differences in EITC "top up"
policies to identify the effects of the EITC. For
example, Kansas has a state EITC program that
provides
16 As noted above, understanding the underlying theory is a 17 percent match on top of the fed-
still valuable for making extrapolations and for welfareeral
anal-EITC amount, whereas Texas has no state
ysis. For example, Allcott (2014) shows that the efficacy of
the social comparison intervention is highly heterogeneous
across cities. If one had a precise theory of why social com-
parisons matter, one might be able to better predict which 17 Tax filers with no dependents are eligible for a very
places would benefit most from this new policy tool. small EITC, with a maximum refund of $457 in 2010.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
minus the income threshold for first kink of

the EITC schedule shown in panel A (the
refund-maximizing kink). The figure plots the
percentage of tax filers in $1,000 bins centered
around the refund-maximizing kink.
In Texas, EITC claimants have a sub-
stantial excess propensity to "bunch" at the
refund-maximizing kink, a result first docu-
mented at the national level by Saez (2010).
More than 5 percent of EITC claimants report
income within $500 of this kink in Texas, much
higher than the density at surrounding income
levels. This is precisely the behavioral response
that one would expect in a neoclassical model
with a nonlinear budget set: since the effec-
tive wage rate falls by 40 percent once one
crosses the kink, many optimizing individuals
should choose to report income exactly at the
refund-maximizing kink.
The degree of sharp bunching is much lower
in Kansas than in Texas. In Kansas, the fraction
of individuals at the refund-maximizing kink is
only slightly higher than at other nearby income
levels. This lower degree of responsiveness to
the EITC is not what one would have predicted
from a neoclassical model, as Kansas offers its
residents a larger EITC than Texas.
To understand what drives this heterogeneity
in EITC response across areas, CFS estimate the
degree of sharp bunching at the refund-maxi-
mizing kink across all the three-digit ZIP codes
(ZIP-3) in the United States. CFS define the
degree of sharp bunching in a ZIP-3 c in year
t bct as the percentage of EITC claimants with
Figure 3. Effects of the EITC on Reported Taxable children who report total earnings within $500
Income of the first EITC kink and have nonzero self-em-
ployment income. CFS focus on self-employ-
Notes: Panel A shows the EITC schedule for single filersment income to define sharp bunching because
with children in 2008 as a function of their reported taxable
the excess mass at the refund-maximizing kink
income. The vertical lines denote the refund-maximizing
is
kink for each group. Panel B reproduces Figure la in Chetty, driven entirely by self-employed individu-
Friedman, and Saez (2013) using data for EITC claimantsals. The distribution for wage earners exhibits
with children in Texas and Kansas. These distributions are
no spike in its density at the kink (see panel A
histograms with $1,000 bins centered around the first kink
of the EITC schedule. Taxable income is the total amount of
of Figure 6 below). Sharp bunching is driven
purely by the self-employed because self-em-
earnings used to calculate the EITC, and is equivalent to the
sum of wage earnings and self-employment income reported ployed individuals directly report their income
on Form 1040 for most tax filers. to the 1RS, making it easier for them to manip-
ulate their reported income to exactly match the
amount needed to obtain the largest refund.18
EITC program. Panel B of Figure 3 plots the

distribution of taxable income for EITC claim- 18 Wage earners have much less scope to manipulate
their reported income, as it is reported directly to the 1RS by
ants with children in Kansas and Texas. The
employers. I discuss the effects of the EITC on wage earners
jc-axis of panel B of Figure 3 is taxable income
in the next subsection.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
Figure 4. Geographical Variation in EITC Sharp Bunching by Year
Notes: This figure reproduces Appendix Figure 3 in Chetty, Friedman, and Saez (2013). It plots self-employed sharp b
rates by 3-digit ZIP code (ZIP-3) in 1996, 1999, 2002, 2005, 2008. Self-employed sharp bunching is defined as the
of EITC-eligible households with children whose total income falls within $500 of the first kink point of the EITC sc
and who have nonzero self-employment income. The observations are divided into deciles pooling all years so that the
cut points are fixed across years. Each decile is assigned a different color on the maps, with darker shades representin
levels of sharp bunching.
Figure 4 presents heat maps of the amount bct of

into ten deciles, pooling all of the years of the
self-employed sharp bunching across ZIP-3s in so that the decile cut points remain fixed
sample
the US in 1996, 1999, 2002, 2005, and 2008.across
This years. Deciles with higher levels of sharp
bunching
figure is constructed by dividing the estimates of bct are represented with darker shades

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
on the map. In 1996, shortly after

expanded to its current form, sharp b
was prevalent in very few areas (southe
New York City, and Miami). Bunchi
spread gradually from these areas to ot
of the country over time. Much of the
in these maps is within states, again su
that differences in state EITC policies
the key determinant of variation in b
responses to the program.
In light of this evidence, CFS set out t
mine why behavioral responses
Figuri: 5. Effects of Moving to Areas with Higher vs.
to
vary so much across areas
Lower Sharp of
Bunching on EITC the Unit
Refunds
Given the spatial diffusion pattern in
one plausible model
Notes: Thisis
figure that the
reproduces Figure variati
3b in Chetty, Friedman,
from differencesandinSaez (2013). The sample in this figure consists
knowledge about of tax- t
payers who move across 3-digit ZIP codes. The figure plots
incentive structure
and learning over tim
changes in EITC refund amounts from the year before the
the neoclassical move
modelto the year aftertypically assu
the move vs. differences in prior res-
all individuals are fully
idents' sharp bunchinginformed abou
rates in the new and old ZIP-3s. The
figure groups individuals
code, in practice many families into bins of width 0.05 based on to
seem
tle understandingtheirof changethe
in sharp bunching
marginaland plots the mean incen
change
in EITC refund amounts within each bin. The solid lines
ated by the EITCshow
(e.g., Smeeding, Ross
linear regressions estimated on the individual-level
and O'Connor 2002).
data separately for the observations above and below 0. The
To test whether differences in knowl- estimated slopes are reported next to each line along with
edge explain the spatial variation, CFS con-
standard errors clustered by bin.
sider individuals who move across ZIP-3s.
The knowledge model predicts that moving
to a higher-bunching area (e.g., from Kansas
CFS go on to show that areas with a larger
to Texas) should increase responsiveness to of EITC claimants tend to have much
density
the EITC. But moving to a lower-bunching
higher levels of sharp bunching bct , consistent
area (e.g., from Texas to Kansas) should
withnot
a model in which knowledge diffuses
affect responsiveness to the EITC, as individ-
through local networks. In sum, a model that
uals should not forget what they have already
accounts for differences in knowledge and learn-
learned. Figure 5 shows that this is precisely
ing - i.e., a model where decision utility v(c'd)
what one finds in the data. This figure is aupon information d - makes much bet-
depends
binned scatter plot of changes in EITC refund
ter predictions about the effects of the EITC than
amounts from the year after the move relative
a model which assumes that all agents are fully
to the year before the move versus the informed
change about the tax code.19
in sharp bunching rates among prior residents
in the destination and origin ZIP-3s. The EITC
B. Earnings Responses : Using Behavioral
refund amount is a simple summary measure Models to Generate Counte rf actuals
of the concentration of the income distribution
around the refund-maximizing kink. The figure As discussed above, the sharp bunching
is constructed by binning the jc-axis variable Aresponse to the EITC is driven entirely by
bct into intervals of width 0.05 percent and plot-
ting the means of the change in EITC refund
within each bin. Individuals to the right of the 19 One may argue that models of imperfect knowledge
dashed line are moving to higher-bunching
and learning are not "behavioral" because they can poten-
areas, while those to the left are moving to low-tially be explained by a neoclassical model with search costs
er-bunching areas. There is a sharp break in thefor acquiring information. The key point here is that incor-
porating such features into the analysis of taxes and labor
slope at 0: increases in bct raise EITC refunds, supply is useful. Whether a model is labeled as "neoclas-
but reductions in bct leave EITC refunds sical" or "behavioral" is inconsequential; what matters is
unaffected. whether that model accurately predicts behavior.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
self-employed individuals. Audit dat

that most of this sharp bunching is dr
misreporting of self-employment incom
than real changes in work patterns
Friedman, and Saez 2013). While und
ing the effects of the EITC on reported
is useful, the objective of the EITC is t
the amount that people actually work
tribute to the economy, not just the inc
report to the 1RS. To study the impact
EITC on labor supply decisions, CFS
terize the program's effects on the dist
of wage earnings, excluding self-emplo
income. Because wage earnings are d
reported by employers to the 1RS on W-
individuals have little scope to misrepo
earnings. Misreporting rates for wage
are below 2 percent (Internal Revenue
1996, Table 3). Hence, changes in wa
ings can be interpreted as changes
labor supply behavior rather than just r
income.
Panel A of Figure 6 plots the distribution of
wage earnings (using data from W-2 forms) in
the United States as a whole for EITC claim-
ants with one child. Unlike with the self-em-
ployed, there is no sharp spike in the density
around the refund-maximizing kink. This is
because wage earners face frictions in choos-
Figure 6. Effects of the EITC on Wage Earnings
ing their labor supply. For example, workers
typically cannot (Altonji and Paxson 1992),
Notes: This figure reproduces Figure 5a in Chetty, Friedman
and Saez (2013). Panel A plots W-2 wage earnings distribu-
making it difficult for them to target a specific
tions for single wage earners with one child, pooling data
level of earnings precisely. Because of these
from 1999-2009 in the United States as a whole. Panel B
frictions, any effects of the EITC on real wage
focuses on the subset of individuals living in the highest and
earnings are too diffuse to detect without a
lowest self-employment sharp bunching deciles, i.e. areas
counterfactual - i.e., an understanding of what
with the highest and lowest levels of information about the
EITC. Self-employed sharp bunching is defined as the per-
the earnings distribution in panel A would look
centage of EITC claimants with children in the ZIP-3-by-
like in the absence of the EITC. This problemyear cell who report total earnings within $500 of the first
lies at the root of why estimating the effects
EITC kink and have nonzero self-employment income. The
of the EITC has been challenging, as there are
series in triangles includes individuals in ZIP-3-by-year cells
few good counterfactuals for programs that in the highest self-employed sharp bunching decile, while
are
the series in circles includes individuals in the lowest sharp
implemented primarily at the national level and
bunching decile. Each distribution is a histogram showing
are changed relatively infrequently. the percentage of observations in $1,000 bins. The EITC
The spatial variation in knowledge about the
schedule is shown on the right y-axis, and the dashed ver-
EITC proves to be very useful in obtaining such
tical lines depict the plateau region of the EITC schedule
a counterfactual and identifying the impactswhere
of individuals obtain the largest EITC refund amounts.
the EITC on wage earnings. The idea is straight-
forward: areas with no information about the
EITC can be used as a counterfactual for behav- To implement this strategy, CFS proxy for
the level of information about the EITC in each
ior in the absence of the marginal incentives cre-
ZIP-3 using the level of sharp bunching among
ated by the program. Intuitively, individuals who
do not know about a program cannot respond to the self-employed, bct. Panel B of Figure 6 plots
its marginal incentives. the distribution of wage earnings for individu-

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
VOL. 105 NO. 5 RICHARD T. ELY LECTURE 1 7
als with one child living in ZIP-3s in t

est decile of sharp bunching (such as s
Texas) versus those living in the lowest
sharp bunching (such as Kansas). There
nificantly more mass in the plateau regio
EITC - between the income levels of
mately $9,000-$ 1 6,000 - in high-info
(high self-employed sharp bunchin
than low-information areas. This sugg
the EITC induces individuals to take
generate earnings that are roughly in t
thatyields the largest EITC refunds, even
cannot perfectly target the refund-ma
kink itself.
The comparisons across areas in pan
Figure 6 could be biased by omitted va
for instance, the industrial structure in
Texas is different from that in Kansas
could lead to differences in the distribution
of wage earnings for reasons unrelated to the
incentive structure of the EITC. To address this
concern, CFS study changes in wage earnings
around childbirth. Individuals without children
are essentially ineligible for the EITC, and hence
the birth of a first child generates sharp variation
in marginal incentives. Panel A of Figure 7 plots
the distribution of wage earnings for individuals
in the highest- and lowest-information deciles in
Figure 7. EITC and Wage Earnings Distributions:
the year before their first child is born. Panel B Changes around Childbirth
replicates panel A using data from the year in
which the first child is born. There are no differ- Notes: This figure reproduces Figure 6 in Chetty, Friedman,
ences in the distribution of wage earnings prior and Saez (2013). The sample includes wage earners living
to childbirth across areas, but as soon as the first in the highest and lowest self-employment sharp bunching
deciles, i.e. areas with the highest and lowest levels of infor-
child is born, the number of individuals in the
mation about the EITC. Self-employed sharp bunching is
EITC refund-maximizing plateau region rises in defined as the percentage of EITC claimants with children in
high-information areas relative to low-informa- the ZIP-3-by-year cell who report total earnings within $500
tion areas. Apparently, people are more likely to of the first EITC kink and have nonzero self-employment
income. Panel A plots W-2 wage earnings distributions in the
continue to work and maintain earnings between
year before child birth. Panel B replicates these distributions
$9,000-$ 16,000 after they have a child in areas for the year of child birth. Each distribution is a histogram
with better knowledge about the EITC 's incen- showing the percentage of observations in $1,000 bins. The
tive structure. dashed vertical lines depict the plateau region of the EITC
schedule for single individuals with one child, where indi-
Building on this approach, CFS show that the
viduals obtain the largest EITC refund amounts.
EITC primarily induces increases in earnings in
the phase-in region rather than reductions in the
phase-out region. They therefore conclude that
the EITC is quite effective in increasing labor focus on short-run changes in behavior around
supply, as intended. The responses to the EITC policy reforms. These studies may have detected
are largest in areas with dense EITC popula- extensive-margin (participation) responses
tions, where knowledge is more likely to spread. because knowledge about the higher return to
In addition to explaining the spatial variation working diffused more quickly than knowledge
in the effects of the EITC, information diffusion about how to optimize on the intensive margin.
can also explain findings from the prior liter- Indeed, surveys show that the knowledge that
ature on the EITC. Most studies of the EITC working can yield a large tax refund - which

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
is all one needs therefore

to know tonew
be used to construct respond
comparison
extensive margin -identify
groups to is treatment
much effects. more w
than knowledge about the nonlinear m
incentives created byInformation
C. Providing the about
EITC
the EITC (e.g.
1998; Romich and Weisner 2002). T
tern of knowledge Given diffusion is ques-
the preceding evidence, a natural consis
a model of rational information
tion is whether we can increase the impacts acqui
of
the EITC by providing to
reoptimizing in response more information
a tax about
refo
extensive margin has That
the program. first-order
is, can one use the insight that (lar
knowledge mediates the effects
fits, whereas reoptimizing on of the
the EITC tointe
gin has develop new policy
second-order tools n (as in Section
(small) benefi II)
2012). rather than just predict the effects of the existing
CFS's analysis illustrates two lessons regard- policies more precisely?
ing the pragmatic value of behavioral econom- Recent studies have investigated this ques-
ics for public policy that can be translated to tion using experiments that provide information
other applications. First, incorporating behav- about the EITC. Chetty and Saez (2013) report
ioral features into the model (in this case, dif- results of an experiment with 43,000 EITC cli-
ferences in knowledge) helps us better predict ents of H&R Block, in which one-half of the tax
the impacts of existing policies (in this case, the filers were randomly selected to receive infor-
effects of the EITC on income reporting behav- mation from their tax preparer about the mar-
ior). Second, behavioral models can be used to ginal incentive structure of the EITC. Chetty and
generate new counterf actual s to estimate pol- Saez find that this intervention had no effect on
icy impacts that would otherwise be difficult to earnings in the subsequent year on average.20
identify, such as the effect of the EITC on wage This finding suggests that it is difficult to manip-
earnings. Similar approaches can be applied ulate information about marginal incentives
to identify reduced-form treatment effects in through policy even though knowledge about
many other contexts. For example, recent stud-the EITC affects behavioral responses to the
ies have shown that individuals exhibit iner- program. This could be because information
tia in choosing health insurance plans (Handelfrom tax preparers has much smaller effects on
2013; Ericson 2014). Such inertia creates individuals'
dif- perceptions than information pro-
ferences in the health insurance plans that indi-
vided on a more regular basis by trusted friends.
viduals have depending upon what plans were Given the apparent challenge in informing indi-
viduals about the EITC, an alternative approach
offered when they joined their current company.
is to include the EITC directly in individuals'
Under the plausible (and potentially testable)
paychecks as an automatic wage subsidy. For
assumption that individuals' underlying health
does not vary at a high frequency across entry
instance, if individuals were quoted an hourly
cohorts within a company, one could exploit
wage rate of $14 per hour instead of $10 per
the cross-cohort variation arising from differ-
hour by their employers, they would not have to
ences in plan availability to identify the impacts
think about the EITC when making labor supply
of insurance plans on health care spending decisions
and at all, and might respond more to the
health outcomes. As another example, Gallagher
higher wage rate.21
Bhargava and Manoli (2014) conduct an
and Muehlegger (2011) show that tax rebates
experiment involving 35,000 individuals who
to buy energy-efficient hybrid cars have much
larger effects on hybrid car sales if they are
framed as sales tax rebates given at the point
20Chetty and Saez (2013) find evidence of heterogene-
of purchase rather than income tax rebates paid
ity in treatment effects across tax preparers, with some tax
when individuals file their income tax returns.
preparers inducing larger earnings responses than others.
By comparing the subsequent behavior of indi- They interpret this finding as evidence that persuasion by tax
viduals who get tax rebates framed in different
preparers may matter more than raw information about the
EITC 's parameters.
ways, one may be able to evaluate the causal
~ 1 A practical complication in implementing this proposal
effects of owning a hybrid car on driving behav-
is that EITC amounts are currently based on annual house-
ior. The general point is that behavioral models
hold income, and hence the marginal subsidy is not known
offer new insights into selection models, and can
until a household's annual income is fully determined.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
were eligible for

predicting
the the effects
EITC of policies
buton behavior.
did no
tax forms needed to
Though such claim
predictions are a key it. Appr
input into
25 percent of EITC-eligible individ
economic analysis, understanding the effects of
file the policies on
paperwork social welfare is equally
needed toimportant.
take up
Bhargava and Manoli
This section turns (2014) find th
to the welfare implications
of behavioral
eligible individuals models. I illustrate these
simplified impli-
inform
cations using
the EITC raises EITC an application to neighborhood
take-up rates sig
effects and housing voucher policies.
One potential explanation for I begin
why
information increases
by summarizing a setEITC take-up
of empirical results on
appears to haveneighborhood
little effectsmean impact
and then discuss neoclas-
ings responses sical that
is and behavioral models
take-upthat fit these facts.
genera
net utility I then
gains discuss optimal
than policy in neoclassical
changing lab
Individuals may versus behavioral models, focusing
rationally pay on recent
more
to information that work that they
develops nonpaternalistic
havemethods left of m
table (which canwelfare beanalysis in behavioral models.
claimed at Finally,
little
relative to information I consider implications for optimal
that policy when ma
their
differs from what we are uncertain
they aboutthought
whether the underlying (whi
real work to generate positive model is neoclassical or and
gains, behavioral.thus
ond-order benefits). Testing this expl
developing new models A. Three Facts about
of Neighborhood
when Effects
and h
edge can be manipulated through pol
be a very useful direction One of the most important
for decisions families
future r
In determining make is where to live. A it
whether large body
is of research
desirab
vide more information about the EITC, it is in sociology and economics has investigated
also important to consider general equilibrium the consequences of neighborhood environ-
effects, as in neoclassical models. Leigh (2010) mental conditions on children's and adults'
and Rothstein (2010) present evidence that part outcomes (e.g., Jencks and Mayer 1990; Cutler
of the benefits of the EITC accrue to employers, and Glaeser 1997; Sampson, Morenoff, and
who reduce wage rates in equilibrium given the Gannon-Rowley 2002). Recent work has used
outward shift in the labor supply curve induced newly available administrative data to identify
by the EITC. Making the EITC more salient - three empirical results about the causal effects
especially by including it in individuals' pay- of neighborhoods that motivate the analysis in
checks as discussed above - could potentially this section.
further reduce wage rates in equilibrium, reduc-First, children's long-term outcomes vary
ing the redistributive value of the program. significantly across neighborhoods conditional
Hence, there may be a trade-off between increas- on parent income. Using data from population
ing labor supply and providing redistribution in tax records covering all children born in the
choosing how to inform individuals about the United States between 1980-1985, Chetty et al.
program's incentives. More generally, incorpo- (2014b) study how children's prospects of mov-
rating firm responses and equilibrium effects ing up in the income distribution relative to their
when predicting the effects of policy changes in parents vary across areas of the United States.
behavioral models is an important area for fur- Chetty et al. (2014b) divide the United States
ther research.22 into 741 commuting zones (CZ), geographic
units that are analogous to metro areas but pro-
IV. Welfare Analysis: Neighborhood Choice vide a complete partition of the United States
based on commuting patterns, including rural
Thus far, we have focused on the positive areas. Figure 8 presents a heat map of a simple
implications of behavioral economics, i.e., measure of upward mobility by CZ: the proba-
bility that a child born to parents in the bottom
quintile of the US income distribution reaches
22 See DellaVigna and Malmendier (2004); Gabaix and
the top quintile of the US income distribution.
Laibson (2006); and Köszegi (2014) for some examples of The map is constructed by dividing commuting
research in this vein. zones into deciles based on this probability, with

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
Figure 8. The Geography of Upward Income Mobility in the United States
Notes: This figure reproduces Appendix Figure VIb in Chetty et al. (2014b). It presents a heat map of upward income m
ity based on de-identified federal income tax records for all children in the 1980-1985 birth cohorts in the United Sta
map is divided into 741 commuting zones. In each commuting zone, upward income mobility is measured by the proba
that a child reaches the top quintile of the national income distribution (for his birth cohort) conditional on having par
the bottom quintile of the national income distribution. Children are assigned to commuting zones based on where the
up (i.e., where they were first claimed as a dependent on a tax return), irrespective of where they live as adults. The com
zones are divided into deciles based on their rate of upward mobility, with lighter colored areas representing areas with
rates of upward mobility.
lighter colored areas representing areas mobility

with is nearly 13 percent, almost three times
higher levels of upward mobility.23 Children's
larger.24
Most of the geographic variation in out-
chances of realizing the "American Dream"
vary substantially across areas. In some areas, comes in Figure 8 appears to be driven by
such as Atlanta or Indianapolis, less than 5causal per-effects of place rather than differences
cent of children born to parents in the bottom in the type of people living in different places.
quintile reach the top quintile. In others, such Chetty
as and Hendren (2015) study 8 mil-
Salt Lake City and San Jose, the rate of upward lion families who move across areas and use
quasi-experimental methods - sibling compari-
sons, exogenous displacement shocks, and a set
of on
23 Children are assigned to commuting zones based placebo tests - to show that neighborhoods
haveascausal effects on children's outcomes.
the location of their parents (when the child was claimed
a dependent), irrespective of where they live as adults.
InThe
particular, they find that spending more of
income quintiles for children are based on their household
one's childhood in an area with higher rates
income in 2011-2012, when they are around age 30, while
parents' incomes are based on mean household income
between 1996-2000. Children are ranked relative to other
children in their birth cohort and parents are ranked relative
24 In a society where parent income has no influence at all
to other parents when constructing income quintiles.on Thechildren's outcomes, we would expect 20 percent of chil-
quintiles are defined based on the national income distribu-
dren growing up in families in the bottom quintile to reach
tion and hence do not vary across areas. See Chetty et al. top quintile. The variation in rates of upward mobility
the
(2014b) for further details on how income and other vari-across areas is quite substantial given that the largest plausi-
ables are measured. ble value of the statistic is 20 percent.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
of upward mobility
B. Neoclassical (i.e., a lighter
versus Behavioral Models of
area in Figure 8) leads Neighborhood
to Choice
higher ea
adulthood. Chetty, Hendren, and K
revisit the Moving toofOpportun
Neoclassical models neighborhood choice
posit that families
experiment, which offered choose to livefamilie
in the area
housing projects subsidized
that maximizes housin
their utility (e.g., Tiebout 1956;
ers to move to Epple and Sieg 1999; Bayer, Ferreira, and
lower-poverty neig
via a randomizedMcMillan 2007). Such models
lottery. They offer twofind
expla-
ing to a lower poverty neighborho
nations for why families do not move to areas
cantly improves where their children do better.
college First, families'
attendance
current neighborhoods
earnings for children who maywere
have advantages
you
such as lower
age 13) when their commuting costs
families or proximity
moved, c
with the quasi-experimental
to friends that offset the gains from
results
moving.
Second, parents
and Hendren (2015). The may have high discount rates
treatment e
moving are or place low weight onchildren
substantial: children's long-term w
lies take up an experimental
outcomes. Hence, it is perfectly plausible
voucher that
low-income
to a lower-poverty area families rationally choose
when they to stay ar
1 3 years old have an annual
in high-poverty environments, andincome
that doing so
percent higher maximizes
relative to
their experienced the con
utility.
in their mid-twenties.
Theories from behavioral
Importantly,
economics suggest
induced by the MTO
several experiment
different explanations for why families
short distances, stay
often less harm
in areas that ultimately than ten
their children.
MTO evidence therefore shows that there is
I consider four such explanations here. First,
models of present bias (e.g., Laibson 1997)
substantial variation in neighborhoods' causal
effects on children's long-term outcomes even suggest that parents may not move because the
at fine geographies (e.g., census tracts),long-term
not gains for children are realized only 10
just at the broad commuting zone level shown or 20 years after the point of the move, but the
in Figure 8. costs of moving must be paid up front.25 Such
The second fact about neighborhood effects present bias may be a particularly strong deter-
that emerges from recent work is that mov- rent to moving because the marginal loss from
ing to a lower-poverty neighborhood has little delaying a move at any given time is small, as
or no impact on adults' earnings. In particu- children's outcomes improve smoothly in pro-
lar, the MTO experiment had little effect on portion to their exposure to a better environment
the earnings or employment rates of adults (Chetty and Hendren 2015). Since there is no
(Sanbonmatsu et al. 2011; Chetty, Hendren, discrete deadline by which one has to move in
and Katz 2015). Hence, parents do not incur order to reap the gains from a better neighbor-
a personal cost in terms of lost earnings when hood, even small fixed costs of moving can lead
moving to an area where their children do a present-biased agent to procrastinate in mov-
better. ing despite the large potential gains from doing
Third, many low-income families live near so (Carroll et al. 2009).
areas that would offer better outcomes for their Second, low-income parents may lack infor-
children without significantly higher house mation about neighborhoods' causal effects on
prices or rents than their current neighborhood. children. Consistent with this view, Hastings
In particular, Chetty and Hendren (2015) show and Weinstein (2008) present evidence that
that the correlation between the causal effect of low-income parents are less likely to choose
a county on children's outcomes and local rents good schools (as measured by students' test
or house prices is less than 0.2 within commut-
ing zones.
Together, these three facts raise a simple 25 Present bias differs from a neoclassical model with
high discount rates because present-biased agents place low
question: why don't parents move to affordable
weight on the future in their decision utility but not their
neighborhoods where their children would do experienced utility, whereas neoclassical agents with high
better? The next subsection discusses a set of
discount rates place low weight on the future in their expe-
models that can answer this question. rienced utility.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
22 A EA PAPERS AND PROCEEDINGS MAY 2015
scores) than alternative explanations parents

high-income by examining new pre-
whe
offered a choice between schools in their area.
dictions would be a very useful direction for
Hastings and Weinstein (2008) show that pro- future work because the neoclassical and behav-
ioral models have quite different implications
viding simplified information about the relative
quality of schools substantially changes the for optimal policy, which I discuss in the next
choices made by low-income parents, suggest- subsection.
ing that they choose worse schools not because
of intrinsic preferences but rather because of a C. Welfare Analysis in Behavioral Models
lack of information.
Third, models of projection bias suggest that I now turn to the normative implications of
individuals may not accurately predict how their the models of neighborhood choice discussed
tastes will evolve when they move to a new above, focusing on whether policymakers should
neighborhood (Loewenstein, O'Donoghue, and seek to influence where low-income families
Rabin 2003). For instance, individuals might live.26 For example, the US federal government
overweight the lost utility from moving away currently provides subsidized (Section 8) hous-
from nearby friends, not fully recognizing ing vouchers to 2.2 million low-income fami-
that they may make new friends in their new lies at a cost of approximately $20 billion (US
neighborhoods. Department of Housing and Urban Development
Finally, recent models of scarcity in cogni- 2014). Are such policies desirable?
tive capacity suggest that poverty can amplify The neoclassical model says that policy
individuals' focus on immediate needs (Shah, interventions that alter neighborhood choices
Mullainathan, and Shafir 2012). At a physiolog- decrease social welfare unless neighborhood
ical level, the stress induced by living in pov- choices have externalities that families do not
erty has been shown to elevate Cortisol levels, take into account when choosing where to
which in turn raises individuals' discount rates live. Such externalities include the benefits to
and amplifies present bias (Haushofer and Fehr
other citizens from having better outcomes for
children - such as reduced rates of crime - as
2014). More generally, individuals have lim-
ited bandwidth to make complex decisions, well as fiscal externalities such as the increased
and living in extreme poverty may focus atten- tax revenue obtained from children who earn
tion on immediate-term needs - such as having more as adults. They could also include inter-
enough food to last through the end of the monthgenerational externalities that arise if parents
underinvest in children relative to the weight
(Shapiro 2005) - rather than searching for infor-
mation and making the longer-term plans needed the social planner places on children's utilities
to find an apartment in a better neighborhood.(Lazear 1983). As we shall see below, the wel-
Note that all of these behavioral models are fare implications of intergenerational external-
ities are very similar to those that emerge from
consistent with the fact that moving to a different
neighborhood has large causal effects on chil- behavioral models.
dren's long-term outcomes but not adults' cur-In contrast with the neoclassical model, the
rent incomes. A higher level of current income behavioral models described above all imply
has an immediate payoff, eliminating discount- that encouraging families to move to areas
ing and projection biases. Moreover, individu- where children do better (e.g., lower-poverty
als are presumably more likely to know about areas) will increase their own private wel-
available jobs in nearby areas than the causal fare and hence is desirable even ignoring any
effects of an area on their child's outcomes sev-
eral years later. Hence, individuals who could
26 Like much of the existing literature in behavioral wel-
immediately obtain a higher salary by moving to
fare economics, this application focuses on a case where
a nearby neighborhood would presumably haveagents' decision utilities differ from their experienced util-
already done so even in the absence of a housing
ities because of behavioral biases. As discussed in Section
voucher encouraging them to make such a move. II, behavioral models can generate new welfare implications
even when agents maximize their experienced utility if they
In summary, the three facts on neighborhood
have nonstandard preferences. For example, Rabin (1993)
effects discussed in Section IVA are consistent
discusses welfare implications in a model where agents have
with both neoclassical models and a variety
tastes for fairness. The implications of such nonstandard
of behavioral models. Testing between these
preferences for optimal policy deserve further exploration.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
externalities. Behavioral models thus call for quality qD(p) = v'~l(p) lies below their true
willingness to pay u'(q), as shown in Figure 9.
using either traditional policy tools (e.g., subsi-
Given a price of p0, the individual chooses
dies) or nudges (e.g., counseling and assistance
in finding a new apartment) to influence neigh-q0 units of neighborhood quality, below the
borhood choice to some degree. utility-maximizing choice of q* where the mar-
To formalize and quantify the implications ginal experienced utility of additional neighbor-
of the two types of models for optimal pol- hood quality equals the price. The lost surplus
icy, consider a special case of the framework from underconsumption - shown by the shaded
in Section I in which individuals make two triangle in Figure 9 - is analogous to the dead-
choices: where to live and how much to spend weight loss that arises from a positive consump-
tion externality (such as an intergenerational
on other consumption goods (y). To eliminate
externality) in the neoclassical model, where
the complexities that arise from discrete choice
of neighborhoods, assume that there is a u'(q)
con-would be social marginal welfare, i.e., pri-
tinuum of neighborhoods that differ in their
vate marginal utility v'(q) plus the externality
impacts on children's long-term outcomes,
benefit of consumption u'(q) - v'(q). As in the
which I refer to as neighborhood "quality" q. Pigouvian taxes to correct externalities,
case of
the optimal policy to correct the "internality"
For example, one may think of q as measuring
depicted
the local poverty rate or school expenditures in in Figure 9 depends upon the differ-
enceof
an area. Let p denote the price of one unit u'q*) - v'q*).
neighborhood quality and normalize the price
Identifying the optimal policy - e.g., the opti-
of v to 1. Letting Z denote the consumer's
mal size of housing voucher subsidies - requires
an for
wealth, we can write y - Z - pq. Assume assessment of how individuals' experi-
enced utilities u'(q) differ from their decisions
simplicity that utility is linear in >?. The individ-
qD(p) = v'(q). This issue lies at the heart of
ual's experienced utility as a function of neigh-
borhood quality is the common concern that behavioral econom-
ics can lead to paternalism, as policymakers'
u(q) + Z - pq perceptions of individuals' experienced utility
u'(q) could be given priority over individuals'
and his decision utility is own choices q (p). Why do policymakers
necessarily have a better sense of where families
v(q) + Z - pq, should live than they themselves do?
The pragmatic approach to addressing these
where u{q) and v(q) are smooth, concave func- concerns about paternalism is to measure u'{q)
tions. The agent chooses q to maximize his deci- empirically without leaving it as a free param-
sion utility, setting v'(q) = p.21 eter at the discretion of policymakers. Recent
This simple framework nests the neoclassical research has developed three nonpaternalistic
and behavioral models described above. In the methods of identifying experienced utility in
behavioral
neoclassical model, u(q) = v(q). In all of the models that resemble methods used
behavioral models described above, individu- to identify the magnitude of externalities in
als underestimate the benefits of neighborhood neoclassical models. Each of these approaches
quality relative to their true willingness to pay has certain advantages and drawbacks, which I
when deciding where to live: v(q) < u(q). As a describe in turn.
result, their observed demand for neighborhood
Method 1: Subjective Weil-Being. - The first
approach is to measure experienced utility
27 1 do not restrict u'(q) > 0 or v'(q) > 0. Living in an
directly using data on self-reported happiness
area that is better for children might have costs such as lower
amenities for parents that drives the marginal utility of mov-
ing to an area that is better for children below 0 beyond some
level of q. This case may be empirically relevant because as 28 This problem does not arise in the neoclassical model,
noted above, in some areas, living in a neighborhood that where v(q) = u(q), because qD(p) coincides with the
produces better outcomes for children does not appear to schedule of marginal utilities by assumption and hence will-
have a significant monetary cost, i.e., p = 0. The only way ingness to pay can be recovered directly from the observed
to explain why demand for q remains finite when p = 0 is demand curve. This revealed preference approach no longer
iív'iq) < 0 for some q. works when decision utility differs from experienced utility.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
Figure 9. Welfare Analysis in Behavioral Models
Notes: This diagram illustrates welfare analysis in behavior models and its connection to wel-
fare analysis of externalities. The lower curve shows the demand function qD(p) that one
would observe in the data as a function of price, which coincides with the agents marginal
decision utility v'(q). The upper curve shows the agent's marginal experienced utility u'(q),
which is the agent's true willingness to pay for the good. In neoclassical models, these two
curves are identical. In behavioral models, the two curves may differ, and the lost surplus from
failing to choose the level of consumption that maximizes experienced utility is depicted by
the shaded triangle. This triangle is analogous to the dead-weight loss that arises from positive
consumption externalities, where social marginal utility (the equivalent of u'(q) here) is higher
than private marginal utility (v'(^)). The challenge for welfare analysis in behavioral models,
as in models with externalities, is identifying u'(q) empirically.
(Diener 2000; Kahneman and Sugden 2005). with the presence of behavioral biases in neigh-
This approach - which is analogous toborhood the choice.
use of contingent valuation methods to assess The subjective well-being approach suffers
externalities (Diamond and Hausman 1994) from -shortcomings analogous to those faced
in the
is attractive in its simplicity and versatility, as contingent valuation literature on
individuals can be surveyed about their hypo-externalities, which are discussed at length
thetical happiness in many settings. Indeed, in Diamond and Hausman (1994). Self-
in the context of the Moving to Opportunity reported measures of happiness can be
experiment, adults who received an experi- systematically distorted by transient contextual
mental voucher to move to a lower-poverty factors, are affected by selective memory
area report significantly higher subjective and projection bias, and do not have a clear
well-being after moving (Ludwig et al. cardinal
2012). interpretation. These problems are
not necessarily insurmountable. For example,
This finding suggests that experienced utility
increased after individuals moved, consistent
researchers have made progress on recall bias

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
by eliciting measures prices of goods - showingof well-bei

the price of the good
time (Stone, Shiffman, inclusive of sales tax - at and DeVrie
a large grocery store
by having individuals reconstruct
and estimate the impact of this intervention on
activities and recall demand. Under
theirthe assumption that individu-
feelings d
episode (Kahneman als maximize
etexperienced
al. 2004). utility when prices
More
Bernheim et include al. taxes,(2013)
Chetty, Looney,propose
and Kroft (2009)
of combining choice recover experienced data with
marginal utilities from su
preferences to form predictions about observed demand when prices include taxes.
preferences that remove systematic biases. They use these estimates to calculate the dead-
Further work is needed to determine whether weight cost of commodity taxes in a representa-
and how subjective well-being metrics can tive-agent
be model.
used to reliably measure experienced utility,Alcott and Taubinsky (2015) use a similar
approach to recover individuals' true will-
but they appear to offer at least some qualitative
information on ex post preferences than can ingness to pay for energy-efficient compact
help mitigate concerns about paternalism fluorescent
in (CFL) light-bulbs in a model that
behavioral welfare economics. permits heterogeneity across agents in behav-
ioral biases and preferences. They give con-
sumers information about the true costs and
Method 2: Sufficient Statistics. - The second
benefits of CFL bulbs relative to standard
method of identifying u'(q) is to return to choice
incandescent bulbs. They then estimate each
data and use revealed preference in an environ-
individual's demand curve for CFL bulbs both
ment z where agents are known to maximize
experienced utility, i.e., an environment z such with and without this information treatment by
that v(q'z) = u(q). Intuitively, if we can find varying the price of CFL bulbs experimentally.
a setting where we can "trust" agents' choices Under the assumption that their information
treatment eliminates all behavioral biases,
as reflecting their true experienced utilities, then
we can back out u'{q) simply from the observed the demand curve post-information coincides
with marginal experienced utilities, u'{q) in
demand curve q D(p ' z) - v'~ 1 (p ' z) . This strategy
Figure 9. They use these estimates to derive
closely parallels "sufficient statistic" approaches
the optimal subsidy for compact fluorescent
to optimal policy in public economics, which seek
to identify optimal policy based on reduced-formlight-bulbs and the welfare gain from correct-
elasticities rather than deep structural parame-ing the internality.
ters (Chetty 2009). 29 This approach is easiest toLike the subjective well-being methodology,
understand in the context of some examples. the sufficient statistic approach does not
Chetty, Looney, and Kroft (2009) implement require specifying the exact behavioral model
this approach in the context of sales taxes and that describes agents' choices. This is attractive
commodity purchases in a grocery store. Their because there are many behavioral models which
analysis is motivated by the observation thatcould generate differences between decision
individuals might not account for sales taxesutility and experienced utility, as illustrated
by the neighborhood choice application. A
(which are not included in posted prices in the
United States) when they make consumption common criticism of behavioral economics is
decisions. To recover the true willingnessthatto it does not offer a single unified framework
pay for these goods, they post tax-inclusiveas an alternative to the neoclassical model. The
sufficient statistic approach provides a method
of handling this problem in the context of
29 This approach is sometimes called a "choice-based"
normative
analysis: if one can find a domain
approach to welfare analysis (Bernheim and Rangel
where agents optimize, one can make robust
2009) or a "reduced-form" approach to welfare analy-
statements about optimal policy that are valid
sis (Mullainathan, Schwartzstein, and Congdon 2012).
Bernheim and Rangel (2009) discuss a more general versionirrespective of the underlying behavioral model.
For example, in the context of neighborhood
of this approach in which one has choice data from settings
with various ancillary conditions (d), following the notation
effects, if the predominant source of bias is that
used in Section II. They show that one can derive bounds on
individuals are uninformed about the benefits
experienced utility from observed choices even if one does
of living in better areas for their children, one
not observe a setting where decision utility perfectly coin-
cides with experienced utility. could identify experienced utility by estimating

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
demand after future utility relative

providing to current utility because
complete info
about the consequences of growing up in of present-bias. Laibson (1997) assumes that
different neighborhoods.30 individuals discount future payoffs exponen-
The drawback of the sufficient statistic tially in their experienced utility (i.e., /3=1).
approach is that one may not always be If this
ableis the true model of behavior, one can
to find an environment z where behavioral identify experienced utility in two steps. First,
biases do in fact vanish. For example, Bordalo,one estimates the structural parameters (ß and
Gennaioli, and Shleifer (2015) propose a model á) using variation in the stream of payoffs over
of salience effects in which a surprise displaytime. Then one simply sets ß = 1 to identify
experienced utility and derive welfare impli-
of tax-inclusive prices as in Chetty, Looney, and
Kroft's (2009) application causes consumers cations.
to For example, Angeletos et al. (2001)
overreact to taxes, thereby leading to mis-es-calibrate Laibson's ß - 6 model using con-
timation of experienced utility. Similarly, sumption
in data and show that individuals exhibit
substantial present-bias when making savings
Alcott and Taubinsky's (2015) application, one
may be concerned that consumers did not fullydecisions, calling for policies to increase sav-
ings rates such as those discussed in Section II.
understand and pay attention to the information
Similarly, Paserman (2008) estimates a model
they were provided on different light-bulbs and
of jòb search with hyperbolic discounting and
hence were not fully "debiased" even after the
uses it to predict the effects of unemployment
information treatment. More generally, if there
benefit policies.
are many behavioral factors at play - not just
inattention but also present bias, cognitive lim- Other behavioral models can be estimated
using a similar structural approach. DellaVigna
itations, etc. - it may be very difficult to identify
settings where all biases are removed. et al. (2014) estimate a model of job search
with reference-dependent preferences and use
Method 3: Structural Modeling. - The third it to make predictions about the optimal time
approach to welfare analysis is to specify andpath of unemployment benefits. A similar struc-
estimate the structural parameters of a behav-tural approach could be used in the context of
ioral model. The logic here is to identify howneighborhood choice by picking one or more
demand varies as a function of the degree of of the behavioral biases discussed above - e.g.,
behavioral bias and then extrapolate to the case
present bias or cognitive limitations - and esti-
mating the parameters of such a model using
with no bias to infer experienced utility. This
approach is analogous to estimating the struc-the techniques applied by Bayer, Ferreira, and
McMillan (2007) in neoclassical models.
tural parameters of the production function for
externalities. The strength of the structural approach is that
Perhaps the most well-known application of it allows us to infer experienced utility from
the structural approach in behavioral models is choice data even if we cannot find domains
Laibson's (1997) quasi-hyperbolic discount- where all behavioral biases vanish. The draw-
ing formulation of present-bias. In Laibson's back - like structural estimation in neoclassical
life-cycle model, individuals making decisions economics - is that it relies on strong model-
at time t - 0 maximize u(c0) + ßYlt Stu(ct), ing assumptions.31 This is well illustrated by
where ct denotes consumption in period Paserman (2008) and work in DellaVigna et
t, u(ct) is the flow utility from consumption in
period t , S denotes the agent's discount factor,
and ß < 1 represents the underweighting of 3 1 In the working paper version of their paper on tax
salience, Chetty, Looney, and Kroft (2007) take a struc-
tural approach to welfare analysis by developing a bounded
rationality model of inattention to taxes. The formulas for
30 As this example illustrates, one typically needs to place the efficiency costs of taxation obtained from this approach
some structure on the behavioral model to understand what illustrate the trade-offs between sufficient statistic and struc-
conditions will produce unbiased choices. However, one
tural approaches to welfare analysis. The sufficient-statistic
may not need to fully specify and parametrize the positive
formulas are more general, but the structural formulas can
be estimated even without data from an environment where
model. For instance, one does not need to specify exactly
why individuals are uninformed about neighborhood effectsagents maximize experience utility and yield additional
in order to recover experienced utility when they are given
predictions about the determinants of the welfare costs of
full information. taxation.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
VOL. 1 05 NO. 5 RICHARD T. ELY LECTURE 27
D. Model Uncertainty and Optimal

al. (2014) on unemployment Policy
benefi
behavioral models. Paserman (2008)
In many situations,
present bias but rules out oneother
may have to make beh
policy
tures that appear todecisions without full information
affect job searc about
such as reference
the underlying
dependence positive model. For instance,
and asbia
(Spinnewijn 2015). DellaVigna
discussed in Section IVB, both neoclassical and et
behavioral models
permit present bias and can fitreference
available evidence de
but do not allow about
for biased
neighborhood beliefs.
effects.33 While futureM
research will hopefully shed
they require the reference point light on theto degree
be
of behavioral biases
by past unemployment in this application
benefit levels- i.e.,
past consumption the ordifference between qD(p) and u'(q)
expectations of in
sumption, which Figure
would
9 - what is the be optimal
an policyequally
given the
available data?
specification (Kõszegi and Rabin 20
one would use more flexible
When faced with specif
uncertainty about the true
each of these models,
model, economists but this
are naturally is
inclined ofte
to use
the neoclassical model
ically and empirically as the default. A more
intractable.32
Although muchprincipled
remains approach is to explicitly
to be account
learn
for
normative analysis in when
model uncertainty behavioral
determining the opti- m
three approaches maldiscussed
policy. This approach once above again followsdem
naturally from established
one can make progress on characterizmethodological tra-
enced utility andditions in neoclassical economics,
optimal policysuch as the in a
nonpaternali stic manner.
literature Importantl
on robust control (Hansen and Sargent
fare implications obtained
2007). Although from
a full treatment of optimal pol- n
models will generally
icy with model uncertaintybe incorrect
is outside the scope
experienced utility
of this paper,
differs
some simple examples from
show that the
utility. Hence, the theneoclassical model should not necessar-
challenges in id
experienced utility ily be givendo prioritynot provide
in the presence of model
for adhering to uncertainty. the neoclassical mod
research on welfare analysis in behav
els is particularly Nudges with Model Uncertainty.
critical because - Consider
ma
debates are already a model with twomotivated
states of the world. Families by
behavioral biases. either
Foroptimizeexample,
as in the neoclassical modelpolicy
such as mandated when choosing neighborhoods or
retirement are biased
and une
savings accountstoward (e.g.,staying in worse areas because of 1998
Feldstein the
and Altman 2007) behavioral
or biases described in Section IVB. prote
consumer
ulations that limit consumers' choice sets are Suppose optimizers are insensitive to nudges
typically justified by behavioral arguments. such
If as counseling on the relative benefits of
economists do not contribute to these debates different neighborhoods. However, behavioral
by analyzing the welfare consequences of these agents are influenced by the way in which dif-
policies in behavioral models, such policies ferent
may neighborhoods are framed. The intuition
be implemented based on paternalistic assump- underlying this assumption is that behavioral
tions rather than empirical evidence. biases are positively correlated. If agents opti-
mize perfectly in choosing neighborhoods, then
they are also likely to be insensitive to fram-
32 The challenges in identifying experienced utility grow If they suffer from behavioral biases when
ing.
larger when one allows for heterogeneity across individuals
in preferences and the degree of behavioral biases. Each of
the approaches described above can accommodate hetero-
geneity, but the data requirements grow much larger. 33 SeeBehavioral and neoclassical models can produce differ-
Allcott and Taubinsky (2015) and Goldin and Reck (2014) ent normative implications even though they produce similar
for methods of identifying the distribution of preferences
positive predictions within a given domain. Of course, there
will always be further tests one could run to discriminate
using a sufficient statistic approach and Carroll et al. (2009)
between the two models; if there is no domain in which the
for an analysis of optimal default policy using a structural
model of present bias and procrastination with heteroge- two models generate different behavior, then they would
neous agents. effectively imply the same underlying decision model.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
choosing where to optimalive,

to begin with) but yields a they
then first-order may
enced by how choices are
gain for behavioral framed
agents (since they under-in- as w
In this environment,
vest in neighborhoodthe quality optimal
in the absence of po
follow the prescriptions ofHence,
the subsidy by assumption). the behavi
once again
and nudge agents thetoward
optimal policy is notmoving
to strictly follow the to b
prescriptionsfor
lower-poverty) areas of the neoclassical
children. model but Nu
optimal irrespective
rather to put someof weight one's prior
on the possibility of
the two modelsbehavioral
because biases. However,it unlike is a weak
with nudges,
it is not optimal to
nant policy. If families put full weight
turn out on the to
behav- be o
ioral model, because
there is no loss from the subsidy imposes famili
nudging a dis-
certain neighborhoods
tortionary cost on because
neoclassical agents. the nu
be ignored.34 But An if
interesting implication of theseturn
families examples ou
behavioral biases, then
is that model uncertaintypolicymaker
can provide a new jus-
welfare by nudgingtification for
families
using nudges instead of to conven-
neigh
where their children will do better. tional policy tools such as subsidies. Nudges
The result that one should exactly follow the are typically justified based on the principle of
prescriptions of the behavioral model rests on libertarian paternalism, as they influence choice
the strong assumption that the nudge has liter- without limiting any individual's options (Thaler
ally no cost if agents optimize.35 But this simple and Sunstein 2003). The examples above sug-
example illustrates that the neoclassical model gest an alternative rationale for nudges: they
should not necessarily be given priority when maximize expected welfare in the presence of
we are uncertain about the true model. Indeed, model uncertainty. Nudges work when agents
there may be good reasons to prioritize behav- make behavioral mistakes, but have no impact
ioral models instead. when they do not, thus providing a more robust
way to correct internalities than tax incentives.36
Subsidies with Model Uncertainty. - NowStudying the optimal combination of nudges and
consider an alternative policy tool in the sameprice incentives in a more general setting with
two-state example above: subsidized housingmodel uncertainty would be a fruitful direc-
vouchers that are financed through a lump- tion for future research in behavioral welfare
sum tax. Housing vouchers affect the behavioreconomics.
of both optimizing and behavioral agents. If
families optimize, the optimal subsidy is zero V. Conclusion
(ignoring externalities), as any subsidy distorts

families' choices relative to their true prefer- The central message of this paper is that the
ences. If families underestimate the benefits of decision to include behavioral factors in eco-
neighborhood quality, the optimal subsidy nomic
is models should be viewed as a pragmatic
positive. If the policymaker seeks to maximize rather thàn philosophical choice. In some appli-
cations, insights from psychology or other social
expected utility given uncertainty about the true
model, the optimal housing voucher subsidy sciences can help us develop better answers by
is strictly positive, a result that follows fromidentifying new policy tools, offering better
O'Donoghue and Rabin's (2006) analysis of predictions of the effects of existing policies,
or producing new welfare implications. In
optimal sin taxes. The reason is that introducing
other applications, one may be able to safely
a small subsidy has a second-order cost for opti-
mizing agents (because they are already at theirignore behavioral factors and use neoclassical
economic models. Decisions about whether to
include behavioral factors in a model should be
treated
34 This assumes that the marginal costs of the nudge (e.g., like other standard modeling decisions,
counseling) are negligible.
Moreover, this simple analysis ignores the equilib-
rium effects of nudges, which could have important wel- 36 Moreover, as illustrated by the results on retirement
fare consequences. For instance, Handel (2013) shows that saving in Section IIA, subsidies may be ignored by agents
who suffer from behavioral biases such as inattention,
nudges that improve individuals' choices in health insurance
markets could reduce social welfare by exacerbating adverse
which may make them particularly ill-suited for correcting
selection. internalities.

103.152.220.46 on Mon, 06 Feb 2023 07:27:10 UTC
such as whether to economics can offer more accurate

assume and robust
quasilinear
separable utility. prescriptions
These for assumptions
optimal policy, again building ar
on familiar methods used to recover individuals'
nient analytical simplifications in some
others, relaxing these
preferences dating
assumptions
to work on externalities by is e
to capture key features
Pigou (1920). Beyondof the problem
these methodological jus-
sense, behavioral tifications,
economics is better
perhaps the most important argument vi
for such a pragmatic
a part of all economists' perspective is that
toolkit it can
(like ot
in applied theory) helprather
us answer some ofthanthe critical policy
as ques-a sepa
field. Dividing ourtions of our time, from
field childhood to
into retirement.
"behavior
"neoclassical" economics is akin to dist
ing "time separable" economists from o
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Behavioral Economics and Public Policy - A Pragmatic Perspective

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