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Optimal Compulsion when Behavioral Biases vary and the State Errs

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Listed:
  • 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.

Suggested Citation

  • Ursula Schwarzhaupt & Salvador Valdés-Prieto, 2010. "Optimal Compulsion when Behavioral Biases vary and the State Errs," Documentos de Trabajo 389, Instituto de Economia. Pontificia Universidad Católica de Chile..
    • Handle: RePEc:ioe:doctra:389
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    File URL: https://www.economia.uc.cl/docs/doctra/dt-389.pdf
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    References listed on IDEAS

    as
    1. Indermit S. Gill & Truman G. Packard & Juan Yermo, 2005. "Keeping the Promise of Social Security in Latin America," IDB Publications (Books), Inter-American Development Bank, number 59998, February.
    2. repec:idb:brikps:59998 is not listed on IDEAS
    3. Ted O'Donoghue & Matthew Rabin, 2001. "Choice and Procrastination," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 116(1), pages 121-160.
    4. Homburg, Stefan, 2000. "Compulsory savings in the welfare state," Journal of Public Economics, Elsevier, vol. 77(2), pages 233-239, August.
    5. Indermit S. Gill & Truman Packard & Juan Yermo, 2005. "Keeping the Promise of Social Security in Latin America," World Bank Publications - Books, The World Bank Group, number 7391, December.
    6. Hans Fehr & Christian Habermann & Fabian Kindermann, 2008. "Social Security with Rational and Hyperbolic Consumers," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 884-903, October.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Andras Simonovits, 2012. "Optimal Cap on Pension Contributions," CERS-IE WORKING PAPERS 1208, Institute of Economics, Centre for Economic and Regional Studies.
    2. András Simonovits, 2014. "Design Errors in Public Pension Systems: The Case of Hungary," CERS-IE WORKING PAPERS 1414, Institute of Economics, Centre for Economic and Regional Studies.
    3. András Simonovits, 2015. "Socially optimal contribution rate and cap in a proportional (DC) pension system," Portuguese Economic Journal, Springer;Instituto Superior de Economia e Gestao, vol. 14(1), pages 45-63, December.
    4. Stefan Domonkos & Andras Simonovits, 2016. "Pensions in transition in EU11 countries between 1990 and 2015," CERS-IE WORKING PAPERS 1615, Institute of Economics, Centre for Economic and Regional Studies.
    5. András Simonovits, 2023. "A rational pension reform package: Hungary, 2025," CERS-IE WORKING PAPERS 2324, Institute of Economics, Centre for Economic and Regional Studies.

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    More about this item

    Keywords

    Behavioral bias; compulsion; optimal policy; time-inconsistency; overoptimism; pensions; maximum taxable earnings;
    All these keywords.

    JEL classification:

    • H55 - Public Economics - - National Government Expenditures and Related Policies - - - Social Security and Public Pensions
    • H53 - Public Economics - - National Government Expenditures and Related Policies - - - Government Expenditures and Welfare Programs
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies

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