May 16, 2017

Thaler's Mental Accounting Error

Behavioral-economics pioneer and University of Chicago Professor Richard Thaler recently retweeted a January 2015 op-ed he wrote for The New York Times titled, "It’s Time to Rethink the Charity Deduction."

Here's an excerpt:
Admittedly, the current tax treatment of charitable donations is not phrased as a subsidy, but that is just semantics. If someone in the 36 percent tax bracket gives $1,000 to charity and deducts it from his income tax, the donation costs him only $640. The government picks up the rest. That’s a subsidy. 
It would be reasonable to ask why the government should subsidize charitable contributions at all.
I'm generally a Thaler fan, but his statement strikes me as exactly wrong. The government doesn't actually 'pick up' anything.

As I understand it, a "subsidy" is the government giving money to an individual or business. A "deduction" is the government not taking money from an individual or business. If someone in the 36% tax bracket gives $1,000 to charity, his contribution costs him $1,000 -- even if he deducts it from his taxable income on his tax forms. If he were unable to deduct it, he would also have to give the government $360. That is, his contribution would cost him $1,360.

It seems even a great professor who pioneered an entire field can fall victim to the false premise that wealth derives from the state and is kept by individuals only at its discretion.

"Tax deductions, like tax exemptions and credits, allow people to keep more of their money in their pockets and out of the pockets of our greedy, profligate Uncle Sam," writes Libertarian author Lew Rockwell. "Only a statist who thinks the government is entitled to a percentage of every American’s income and that tax deductions deprive the government of its claim to that percentage could object to Americans holding on to more of their own money."

To be perfectly honest, though, I fall into this trap. I often find myself talking about business spending as being "subsidized" by the government. When I spend $100, I imagine I am only spending $65. But no, I actually spent the $100. Not having to pay the government an additional $35 on the income I used for expenses is not the same as the government splitting the bill with me -- even though the inevitably of paying taxes may make it seem that way.

What's fascinating to me is that this is exactly the sort of odd human misjudgment Professor Thaler helped bring to the world's attention. It's of a piece with what he describes as flawed "mental accounting." A being of pure reason -- Thaler's "Econ" -- would not make the mistake of thinking his charitable giving or business spending involved contributions from the government. But a Human mentally puts a rough percentage of his own income into the government's account and then rejoices when he gets to take some money out of that account. He experiences the joy of a gain even though what has actually happened is that he has not lost.

In other words, Humans accept government confiscation as the natural order of things. Perhaps someone needs to re-introduce them to a third category of being: the Freeman.


Update: Thanks to a June 12, 2017 Twitter exchange with Professor Russ Roberts, I learned that a "subsidy to an economist means 'something that makes something else cheaper or easier to buy.'" He adds: "It's not usually a philosophical point," and argues "tax deductibility of charity is a subsidy to charity." Perhaps I misunderstood Prof. Thaler's point, then. He is a founder of behavioral economics, after all.

Through further research, I learned that tax breaks are considered an "indirect" subsidy. But in the same Wikipedia entry I read: "Tax breaks are often considered to be a subsidy. This requires the assumption that a person's or an entity's money belongs to the government." So it seems we are right back at the same point -- albeit a philosophical not economic one -- that inspired the above post.