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Optimal Compulsion when Behavioral Biases vary and the State Errs

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  • Ursula Schwarzhaupt
  • Salvador Valdés-Prieto

Abstract

When behavioral biases have varying sizes, and the State seeks to correct behavior through compulsion, the question is how to design optimal compulsion. One argument is that compulsion should rise with the size of the bias to be “cured”. A contrary argument is that since compulsion affects actions, and recommended actions are independent from the bias, compulsion should not depend on the bias. This puzzle is solved for the case where individuals are affected by a bias that leads them to under-save, acknowledging that the planner predicts each individual’s optimal action with error. Since only low-bias individuals are willing to correct the planner’s mistakes when mandated to save too little, but are not able to do so in the opposite direction due to a costly spread, the optimal amount of compulsion rises with the bias. As an application, the paper explores a behavioral rationale for a Maximum for Taxable Earnings (MTE). It finds that if (1) the State’s information is limited to current earnings; (2) earnings do not influence the earnings ratio for old age; and (3) the bias falls only at the highest earnings quintile, then a MTE near the 80th percentile of the earnings distribution is optimal.

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Bibliographic Info

Paper provided by Instituto de Economia. Pontificia Universidad Católica de Chile. in its series Documentos de Trabajo with number 389.

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Date of creation: 2010
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Handle: RePEc:ioe:doctra:389

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Keywords: Behavioral bias; compulsion; optimal policy; time-inconsistency; overoptimism; pensions; maximum taxable earnings;

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  1. Homburg, Stefan, 2000. "Compulsory savings in the welfare state," Journal of Public Economics, Elsevier, vol. 77(2), pages 233-239, August.
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Cited by:
  1. Andras Simonovits, 2012. "Optimal Cap on Pension Contributions," IEHAS Discussion Papers 1208, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.

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