American Economic Review: Papers & Proceedings 2015, 105(5): 1–33 http://dx.doi.org/10.1257/aer.p20151108 RICHARD T. ELY LECTURE Behavioral Economics and Public Policy: A Pragmatic Perspective† By Raj Chetty* Starting with Simon 1955 , Kahneman and of each viewpoint in different settings e.g., List Tversky 1979 , and Thaler( 1980) , a large body 2004; Levitt and List 2007; DellaVigna( 2009 . of research( has) incorporated( insights) from psy- In this paper, I approach the debate )on chology—such as loss aversion, present bias, and behavioral economics from a more pragmatic, inattention—into economic models.1 Although policy-oriented perspective. Instead of pos- this subfield of behavioral economics has grown ing the central research question as “Are the very rapidly, the neoclassical model remains the assumptions of the neoclassical economic benchmark for most economic applications, and model valid?,” the pragmatic approach starts the validity of behavioral economics as an alter- from a policy question for example, “How 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 in methodology of positive economics advocated market settings? This debate has proved to be by Friedman 1953 , who argued that it is more contentious, with compelling arguments in favor useful 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: [email protected] . Prepared for the Richard T.( Ely Lecture, American Economic) argue that modern evidence calls for incorpo- Association, January 3, 2015. A video of the lecture is rating behavioral economics into the analysis of available. I thank Saurabh Bhargava, Stefano DellaVigna, important economic questions. 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 helpful com- Each of these domains has a long intellectual ments and discussions. I am very grateful to my collabo- tradition in economics, showing that from a rators John Friedman, Nathaniel Hendren, Lawrence Katz, pragmatic 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 a challenge to neoclassical economic( methods. for their contributions to the studies discussed in this paper. ) Augustin Bergeron, Jamie Fogel, Michael George, Nikolaus First, behavioral economics offers new pol- Hildebrand, and Benjamin Scuderi provided outstand- icy tools that can be used to influence behavior. ing research assistance. This research was funded by the National Science Foundation. † Go to http://dx.doi.org/10.1257/aer.p20151108 to visit 2 I 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 1 Although the implications of psychology for economics as technology. have been formalized using mathematical models only in 3 In a widely cited example, Friedman points out that recent decades, some of these ideas were discussed quali- the 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 Loewenstein the assumption that the player himself knows and applies 2005 . ( these formulas is likely to be incorrect. ) 1 2 AEA PAPERS AND PROCEEDINGS MAY 2015 Insights from psychology offer new tools—such year to subsidize retirement saving in 401 k as changing default options or framing incen- and IRA accounts Joint Committee on Taxation( ) tives as losses instead of gains—that expand the 2012 . I summarize( recent evidence showing set of outcomes that can be achieved through that such) subsidies have much smaller effects on policy. This expansion of the policy set parallels savings rates than “nudges” Thaler and Sunstein the transition in the public finance literature 2008 such as defaults and automatic( enrollment from studying linear commodity taxes Ramsey plans) that are motivated by behavioral models of 1927 to a much richer set of nonlinear (tax poli- passive choice. These new policy tools allow us 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 rienced utility his actual well-being , and the decisions. The EITC provides subsidies that are agent’s decision( utility the objective) the agent intended to encourage low-wage individuals to 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- experienced utilities improves predictions about sity of EITC claimants have greater knowledge the welfare consequences of policies. The dif- about the parameters of the EITC schedule and, ference between the policymaker’s and agent’s accordingly, are more responsive to the program. objectives in behavioral models parallels non- These differences in knowledge across areas pro- welfarist approaches to optimal policy Sen vide new counterfactuals to identify the impacts ( 1985; Kanbur, Pirttilä, and Tuomala 2006 and of the EITC on labor supply decisions and reveal the techniques used to identify agents’ experi) - that the program has been quite successful in enced utilities resemble those used in the long increasing 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 appli- EITC, accounting for the differences in knowl- cations drawn from recent research. The appli- edge 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 increase families’ 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 VOL. 105 NO. 5 RICHARD T. ELY LECTURE 3 for children yet do not have higher housing costs. change behavior and increase welfare if agents Both neoclassical models and models featuring suffer from behavioral biases without distorting behavioral biases e.g., present-bias or imperfect behavior if agents optimize. Model uncertainty information can (explain why families do not can thus provide a new argument