Dealing with the irrational at Budget time

by on April 9, 2018

THE Treasurer and others might well look to behavioural psychology and behavioural economics when framing the Budget, but we would be better off if they ignored them. It took several decades for mainstream economists to accept that the economists’ view of the world was essentially flawed.

For a long time, classical economists worked on the theory that humans act rationally in their self-interest to maximise utility, so people should be given as much choice as possible and markets will sort everything out for the benefit of all.

Then along came the behavioural psychologists who proved this was wrong. They showed that people were not rational and often did not act in their own best interests. In particular, people were averse to loss.

Given a choice between a certain gift of $500 or a toss of a coin with tails yielding zero and heads yielding $1100, nearly everyone takes the certain $500. This is despite the fact that the 50 per cent chance of more than double the $500 is clearly worth more than $500.

However, given a choice between a certain loss of $500 or a toss of a coin to avoid that risk with tails being no loss and heads being a loss of $1100, nearly everyone chooses to take the risk of a toss of the coin. This is despite the fact that the 50 per cent chance of more than doubling in the loss is clearly worth less than taking the $500 loss up front.

The Israeli-American psychologist Daniel Kahneman (pictured) did thousands of questionnaires during decades of research showing how easily people are diverted from rational assessments and decision-making.

The fact he was awarded the Nobel Prize for Economics in 2002 was recognition by mainstream economics that the assumptions upon which it based its theories, predictions and conclusions were utterly flawed.

However, it has not stopped many economists still glorifying market solutions and more importantly, calling for smaller government because people will make rational choices.

Of course, if they did, there would be no poker machines, among other things.

Sometimes the context or the way something is phrased can make it look like a loss rather than a gain. If a trader is expecting a $1 million bonus and gets $500,000 bonus, it is a gain, but the trader sees it as a loss. If the trader gets $1 million, it looks like a gain. But if all the other traders get $2 million bonuses, it is seen as a loss.

So, it is not the absolute value or utility that drives the answer but the context.

With the Budget, it seems the government is well aware of behavioural psychology. For a start, it has only hinted at tax cuts. If it builds up expectations, unless the tax cuts are very large they might be seen as a loss. If people at the lower end get less than people on the higher scales it will again be seen by them as a loss.

This government, like most recent governments, is swayed by the mantra of no-one being worse off.

Voters are extremely loss averse. They look at losses and gains asymetrically. They treat a small loss (extra tax or cut in benefit) as of much greater consequence than a greater gain.

Governments are alert to this. It explains why cutting government spending is so difficult. The only spending recently that has been easy to cut is foreign aid. It is about the only area where a cut is not a loss to a voter.

Behavioural psychologists point out that humans do not behave rationally. It is more unfortunate, however, that in a democracy politicians have to factor in that irrationality when making decisions, simply because voters will turn on them if they do not.

That may explain why “poll-driven politics” was for a long time a term of derision. If you pander to voters, you are pandering to the irrational. It might also explain why a rational, sensible policy was termed “courageous” in the “Yes, Minister” series. If you made a sensible decision, you needed courage to face the wrath of the irrational.

Education is a classic case in point. The first iteration of Gonski delivered a rational prescription for spending on education. It required some extra money but also a reallocation of the total pool of federal and state funding so that schools with less advantaged students got more.

Within a short time, loss aversion came to the fore: “Will you guarantee that no school will be worse off.” The Gillard Government fell for it and promised extra funding so no school would be worse off.

By doing so she guaranteed that in fact everyone would be worse off.

Not redirecting money to the lowest performing students will cost Australia at least $120 billion over the next 45 years according to an OECD formula applied in research published this week by the Public Education Foundation.

It stands to reason. If you spend too much on top-performing students in top, well-funded schools you will not get much extra performance for your dollar. If you spend more on poor-performing students you get better performance immediately – a much more rational outcome.

Alas, behavioural psychology tells us that parents of students at individual schools which face a funding cut will want to avert that “loss”. They will campaign and scream and make life difficult for the courageous politician making the rational decision.

Before government makes a decision that will impose a “loss” on anyone, it has to be confident that the “loss” is imposed only voters unlikely to vote for them. This perhaps explains why overall reforms with “gives” and “takes” has become almost impossible, whether in education, health or tax, even if overall everyone would be better off in the long run.

Loss aversion is so strong that any advantages either immediate or long-term are hardly considered.

And this is even before we consider the influence of donors on the political process.
CRISPIN HULL
This article first appeared in The Canberra Times and other Fairfax Media on 7 April 2018.

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