Behavioural Economics: An Excuse To Tax And Regulate

Few areas of study are as fashionable as behavioural economics – the integration of psychological factors into economic analysis.

No wonder. Behavioural economics seems tailor-made for public policy. If people do not act rationally and do not pursue their own best interests, then perhaps markets aren’t that good. From there, the case for government intervention seems pretty obvious.

Two of Australia’s left-wing think tanks, the Centre for Policy Development and Per Capita, have released reports specifically on the implications of behavioural economics. And it is a rare paper from the Australia Institute which doesn’t discuss how market actors are riddled with biases, psychological flaws, and irrationalities. Therefore, they all conclude, governments need more power. There’s hardly a regulation or tax that hasn’t been justified by reference to the behavioural economics literature.

But the public policy implications of behavioural economics are more interesting than that.

The study of behavioural economics has largely focused on the irrationality of participants in the market. Yet there are two sides to policymaking. Regulators, bureaucrats, and politicians are just as affected by psychological ticks as consumers and businesses.

A newly published paper in the Journal of Regulatory Studies, “Behavioural economics: implications for regulatory behaviour” makes the obvious point: if the claims made by this field are right, then it should make us think just as sceptically about government action as consumer action.

After all, it would be no good to destroy the myth of Homo Economicus just to replace it with an equally pernicious myth of Homo Bureaucratus – a clearheaded and efficient policy designer.

There is no reason to believe that someone moving from the private sector to the public sector suddenly becomes more rational and unbiased. The dispassionate, rational economic actor might be a convenient fiction dreamt up by modellers and theoreticians, but then so is the dispassionate, rational, unbiased policymaker.

The paper’s authors, James C Cooper and William E Kovacic, look specifically at anti-trust law, where behavioural economics is commonly used to study business decisions to enter or exit markets, to merge with other firms, or split. Cooper and Kovacic argue that the bureaucrats who regulate those decisions are likely to have biases that undermine the effectiveness of government intervention.

Regulators are like the rest of us. They are over-confident, thinking they can understand complex behaviour. Hindsight bias leads them to believe events are more predictable than they are. And, unsurprisingly, they are driven by action bias – a tendency to favour interventionist solutions when faced with a problem.

In fact, regulatory biases could be worse than market ones. Behavioural economics tells us that irrationality is everywhere. But the marketplace provides firms and consumers with instant or near-instant feedback. In a competitive market, psychological bias can lead to failure or loss of market-share. With such feedback, market participants will change their actions. Make a mistake, lose money… do better next time.

By contrast, regulators receive little feedback at all. They operate in a political world, not an economic one. Regulatory or bureaucratic error is hard to pin down. It’s harder to allocate blame for errors. It’s even harder to quantify the costs of those errors.

Market participants learn from their mistakes. But regulators are completely isolated from the consequences of their decisions, so it’s much harder for them to learn.

Compounding that, confirmation bias – where the introduction of new, ambiguous information leads to the unjustified hardening of previous conclusions – may steer regulators and their political masters to believing a policy has been a triumph when it has not.

Indeed, even what constitutes success or failure in the public sector is debatable. Few policies have defined criteria whereby we can determine if they have succeeded or not.

In the Centre for Policy Development’s 2008 paper, You Can See a Lot by Just Looking: Understanding human judgement in financial decision-making, Ian McAuley rightly points out that humans are susceptible to the fallacy of sunk costs.

“We find it very difficult,” McAuley writes, “to make decisions solely on the basis of future costs and benefits, particularly if it means implicitly admitting that we have made poor decisions in the past”.

This is true for private actors, but is especially true for governments. Old bureaucracies never die – they just get renamed. Subsidies survive long past their use-by date. And taxes are stubborn things.

So far, the policy debate around behavioural economics has led with ideological conclusions – apparently offering those who believe governments should tax and regulate more a cutting-edge reason for doing so.

But if we want to fully understand the implications of behavioural economics, we’ll have to recognise that the field offers an even harsher critique of government than it does of markets. And the safe money says policy makers and bureaucrats will not enjoy the spotlight on them.