These are slides from a presentation to the Gruter Institute for Law and Behavioral Research, Squaw Valley Conference, May, 2008 (at which event Michael Jensen got me to agree to post these slides as a pdf on SSRN . . . ).
The task is to give an overview of what I hope to be an emerging field of behavioral public finance. Behavioral finance, as per Barberis and Thaler 2003 (and others), consists of two parts: (1) individual level heuristics and biases, which can lead to sub-optimal (inconsistent) judgment and decision-making, and (2) institutional arbitrage mechanisms. In private finance and economics, these latter, most importantly competition and markets, act to reduce and perhaps eliminate the “harms” from the former. Hence we get the relatively modest policy recommendations characteristic of Sunstien and Thaler’s Nudge (among many other examples), such as for default rules that set participation in 401(k) plans. In public finance, in contrast—and arguably in all sectors of the economy where there are not flourishing markets (such as among the poor?)---there are no obvious arbitrage mechanisms. Politicians and the political processes can even exacerbate persistent cognitive error: consider the predilection for hidden taxes, such as the corporate tax. Behavioral public finance is a hugely important subject matter.
These slides, summarizing original research done with Jon Baron of Penn (see the survey piece, McCaffery and Baron 2006), explain the general setting; group together many biases under a common isolation effect, and then use Kaplow and Shavell 2002’s model of optimal legal system design, tracking the two welfare theorems—i.e., set rules (including, we argue, public finance rules), so as to maximize wealth or serve efficiency, and then redistribute from the greater social pie via the tax system---to suggest the possible problems for a democracy. These include: (a), leaving wealth on the table, because the optimally psychologically pleasing policy is not the most efficient one; (b) pitting equity or redistribution against efficiency, unnecessarily, because support for redistribution depends on the purely formal aspects of public finance; and (c) allowing skilful politicians to affect preference reversals among the citizenry, by agenda setting and framing, as by getting citizens averse to deficits and in favor of government expenditures to cut taxes, today, by isolating tax cuts from spending programs.
Available at: http://works.bepress.com/edward_mccaffery/15/