Rebuttal of Hashimzade, Myles and Tran-Nam (2009) “New Approaches to the Economics of Tax Evasion”
(file size: 208K, last updated: 01/2010)
In a recent, 58 page, paper, Hashimzade, Myles and Tran-Nam (2009) "New
Approaches to the Economics of Tax Evasion" survey alternative approaches to tax
evasion. Their central conclusion is, in their own words (p. 56): "What they [the
non-expected utility models] do not do is change the relationship between the tax
rate and the level of evasion." We show that their central conclusion is incorrect. We
also show that their representation of our work [(2007) "Why Do People Pay Taxes?
Prospect Theory Versus Expected Utility Theory", Journal of Economic Behavior
and Organization, 64: 171-192 ] is highly misleading, and incorrect.
In an overlapping generations economy with endogenous income growth, I combine themes from the work of Cooper et al. (2001), Kapur (2005), and Eaton and Eswaran (2009) in order to provide an example of an economy whose welfare dynamics are non-monotonic. Particularly, the evolution of workers’ welfare can be distinguished between two different regimes that arise naturally during the process of economic development. At relatively early stages, status concerns are inactive and welfare increases following the rising consumption of normal goods. During the later stages, however, workers
engage in some type of status competition that does not allow consumption to improve well-being: their welfare actually declines as successive generations of workers increase their labour effort at the expense of leisure.
Labour Market Effects of Eastern European Migration in Wales
(file size: 1.20MB, last updated: 01/2010)
The enlargement of the European Union in May 2004 triggered a relatively large and rapid migration inflow into Wales which was concentrated into narrow areas and occupations. As this inflow was larger and faster than anticipated, it arguably corresponds more closely to an exogenous supply shock than most migration shocks studied in the literature. This helps to some extent to circumvent identification issues arising from simultaneity bias which usually pose difficulties when estimating the effect of migration inflows on the labour market. We found little evidence that the inflow of accession migrants contributed to a fall in wages or a rise in claimant unemployment in Wales between 2004 and 2006. In particular, we found no evidence of an adverse impact on young, female or low-skilled claimant unemployment and no evidence of an adverse impact on the wages of the low-paid. If anything, we found a positive effect on the wages of higher paid workers and some weak evidence of a potentially favourable impact on claimant unemployment.
Off-the-peak preferences over government size*
(file size: 486K, last updated: 01/2010)
We study the political consequences of policy preferences which are non-symmetric around the peak. While the usual assumption of symmetric preferences is innocuous in political equilibria with plat-forms convergence, it is not neutral when candidates are differentiated. We show that a larger government size emerges when preferences of the median voter off-the-peak are more intense towards overprovision (what we call wasteful preferences), whereas a smaller government results when her preferences are more intense towards underprovision (scrooge preferences). We then analyze the determinants of preferences off-the-peak and find that: (i) The sign of the third derivative of the policy-induced utility function indicates whether preferences are wasteful (positive) or scrooge (negative). (ii) The analog of Kimball's coefficient of prudence can be used to measure degrees of wastefulness and scroogeness. (iii) Consumers' risk aversion and government decreasing effectiveness in producing the public good generate scrooge.
Assortative Matching in Partnerships and
(file size: 143K, last updated: 09/2010)
This paper argues that assortative matching can explain over-education. Education determines individuals' income and, due to the presence of assortative matching, the quality of the partner, who can be a colleague or a spouse. Thus an individual acquires some education to improve the expected partner's quality. But since everybody does that, the expected partner's quality does not increases and over-education emerges. Public intervention can solve over-education through a progressive income tax.
Financial Restraints and Private Investment: Evidence from a Nonstationary Panel*
(file size: 203K, last updated: 02/2010)
We employ recently developed panel data methods to estimate a model of private investment under financial restraints for 20 developing countries using annual data for 1972-2000. We show that the qualitative nature of the results varies depending on whether we take into account cross-country e¤ects. When we allow for cross-sectional dependence, investment displays more sensitivity to
world capital market conditions and exchange rate uncertainty. A perhaps even more surprising result is the finding that countries that managed to suppress domestic real interest rates without generating high inflation enjoyed higher levels of private investment than those that would have been obtained under liberalized conditions.
Sex and the Uni: Higher Education Effects in Job
and Marital Satisfaction*
(file size: 177K, last updated: 09/2010)
This paper examines how educational decisions a¤ect job and marital satisfaction. We build up a model with educational assortative matching where individuals decide whether to attend university both for obtaining job satisfaction and for increasing the probability to be matched with an educated partner. The educational choices between future partners are simultaneously determined as a Nash equilibrium. The theoretical results suggest that, as assortative matching increases, the proportion of educated individuals increases. For educated individuals, job satisfaction falls and marital satisfaction increases. We test our model using the British Household Panel Survey. We carry out longitudinal analysis for years 2003-2006. Our empirical findings support the theoretical results.
Charitable Giving and Optimal Public Policy in a Competitive Equilibrium with Multiple Equilibria.
(file size: 869K, last updated: 03/2010)
In a competitive-equilibrium analysis of giving to charity, we show that strategic complementarity between individual giving and aggregate giving can lead to multiple equilibria. This provides a possible explanation for observed heterogeneity in giving. It is possible, but not necessary, that at a low equilibrium in giving (LE), an increase in subsidy reduces giving (perverse comparative statics) while at a high equilibrium (HE) the comparative statics are normal (subsidies promote giving). The perverse comparative statics at LE preclude using subsidies to move the economy to HE. We show how temporary direct government grants can engineer a permanent move from LE to HE. Once HE is established, the optimal mix of private and public giving is determined using a welfare analysis. We show that the Nash non-cooperative outcome is virtually identical to the competitive-equilibrium, even for relatively small numbers of givers. The competitive-equilibrium approach is more tractable and plausible, and more general because it does not rely on a symmetric equilibrium. We also show how our results are applicable to redistributive and public good contexts.
Decision-Based Forecast Evaluation of UK Interest Rate Predictability*
(file size: 874K, last updated: 09/2010)
This paper illustrates the importance of density forecasting in portfolio decision making involving bonds of different maturities. The forecast performance of an atheoretic and a theory informed model of bond returns is evaluated. The decision making environment is fully described for an investor seeking to optimally allocate his portfolio between long and short Treasury Bills, over investment horizons of up to two years. Using weekly data over 1997 to 2007 we examine the impact of parameter uncertainty and predictability in returns on the investor's allocation. We describe how the forecasts are computed and used in this context. Both statistical and decision-based criteria are used to assess the out-of-sample forecasting performance of the models. Our results show sensitivity to the evaluation criterion used. In the context of investment decision making under an economic value criterion, we find some potential gain for the investor from assuming predictability.
Probability Weighting Functions*
(file size: 391K, last updated: 04/2010)
In this paper we begin by stressing the empirical importance of non-linear weighting of probabilities, which expected utility theory (EU) is unable to accommodate. We then go on to outline three stylized facts on non-linear weighting that any alternative theory of risk must address. These are that people: overweight small probabilities and underweight large ones (S1); do not choose stochastically dominated options when such dominance is obvious (S2); ignore very small probabilities and code extremely large probabilities as one (S3). We then show that the concept of a probability weighting function (PWF) is crucial in addressing S1-S3. A PWF is not, however, a theory of risk. PWF's need to be embedded within some theory of risk in order to have significant predictive content. We ouline the two main alternative theories that are relevant in this regard: rank dependent utility (RDU) and cumulative prospect theory (CP). RDU and CP explain S1,S2 but not S3. We conclude by outlining the recent proposal for composite prospect theory (CPP) that uses the composite Prelec probability weighting function (CPF). CPF is axiomatically founded, and is flexible and parsimonious. CPP can explain all three stylized facts S1,S2,S3.
Composite Prospect Theory: A proposal to combine ‘prospect theory’ and ‘cumulative prospect theory’
(file size: 586K, last updated: 04/2010)
Evidence shows that (i) people overweight low probabilities and underweight high probabilities, but (ii) ignore events of extremely low probability and treat extremely high probability events as certain. The main alternative decision theories, rank dependent utility (RDU) and cumulative prospect theory (CP) incorporate (i) but not (ii). By contrast, prospect theory (PT) addresses (i) and (ii) by proposing an
editing phase that eliminates extremely low probability events, followed by a decision phase that only makes a choice from among the remaining alternatives. However, PT allows for the choice of stochastically dominated options, even when such dominance is obvious. We propose to combine PT and CP into composite cumulative prospect theory (CCP). CCP combines the editing and decision phases of PT into one phase and does not allow for the choice of stochastically dominated options. This, we believe, provides the best available alternative among decision theories of risk at the moment. As illustrative examples, we also show that CCP allows us to resolve three paradoxes: the insurance paradox, the Becker paradox and the St. Petersburg paradox.
The Behavioral Economics of Insurance
(file size: 540K, last updated: 04/2010)
We focus on four stylized facts of behavior under risk. Decision makers: (1) Overweight low probabilities and underweight high probabilities. (2) Ignore events of extremely low probability and treat extremely high probability events as certain. (3) Buy inadequate insurance for very low probability events. (4) Keeping the expected loss fixed, there is a probability below which the take-up of insurance drops dramatically. Expected utility (EU) fails on 1-4. Existing models of rank dependent
utility (RDU) and cumulative prospect theory (CP) satisfy 1 but fail on 2, 3, 4. We propose a new class of axiomatically-founded probability weighting functions, the composite Prelec weighting functions CPF) that simultaneously account for 1 and 2. When CPF are combined with RDU and CP we get respectively, composite rank dependent utility (CRDU) and composite cumulative prospect theory (CCP). Both CRDU and CCP are able to successfully explain 1-4. CCP is, however, more satisfactory than CRDU because it incorporates the empirically robust phenomena of reference dependence and loss aversion.
The Economic Value of Stock and Interest Rate Predictability in the UK
(file size: 1050K, last updated: 04/2010)
This paper examines asset return predictability by comparing the out-of-sample forecasting performance of both atheoretic and theory informed models of bond and stock returns. We evaluate forecasting performance using standard statistical criterion, together with a less frequently used decision-based criterion. In particular, for an investor seeking to optimally allocate his portfolio between bonds and stocks, we examine the impact parameter uncertainty and predictability in returns have on how the investor optimally allocates. We use a weekly dataset on UK Treasury Bill rates and the FTSE All-Share Index over the period 1997 to 2007. Our results suggest that in the context of investment decision making under an economic value criterion, the investor gains from not only assuming predictability but by modelling the bond and stock returns together.
The Behavioral Economics of Crime and Punishment
(file size: 408K, last updated: 07/2010)
The Becker proposition (BP) is one of the founding pillars of the modern literature on Law and Economics. It states that it is optimal to impose the severest possible punishment (to maintain e¤ective deterrence) at the lowest possible probability (to economize on enforcement costs). The BP is not consistent with the evidence. This is known as the Becker paradox. Using evidence from a wide range of phenomena we show that none of the proposed explanations for the Becker paradox are satisfactory. The BP has largely been considered within an expected utility framework. We clarify the Becker proposition and its welfare implications under expected utility. We show that BP also holds under rank dependent expected utility and cumulative prospect theory, the two main alternatives to expected utility. al-Nowaihi and Dhami (2010a) recently propose composite cumulative prospect theory that combines prospect theory with cumulative prospect theory. Under plausible conditions CCP is able to resolve the Becker paradox. Our article opens the way for incorporating non-expected utility theories into an economic analysis of criminal activity.
Learning without Counterfactuals*
(file size: 295K, last updated: 02/2010)
In this paper we study learning procedures when counterfactuals (payo s of not-chosen actions) are not observed. The decision maker reasons in two steps: First, she updates her propensities for each action after every payo experience, where propensity is de ned as how much she prefers each action. Then, she transforms these propensities into choice probabilities. We introduce natural axioms in the way propensities are updated and the way propensities are translated into choice, and study the decision marker's behavior when such axioms are in place.
Reconsidering the Fiscal Effects of Constitutions
(file size: 265K, last updated: 05/2010)
This paper reconsiders Persson and Tabellini’s (2003,2004) analysis of the causal effect of constitution type on government size, it addresses the concerns of Acemoglu( 2005) and makes some further refinements to argue that there is a qualitatively large, and statistically significant relationship between constitution type and government size. The age of a democracy is of increased importance in the new identification strategy, but existing measures are shown to be flawed. Two new measures of the age of a democracy are introduced. The first details when a country first had a genuinely democratic election, the second when its current constitution was promulgated.
A Model of Party Formation and Competition*
(file size: 2,876K, last updated: 09/2010)
This paper investigates the behaviour of a Citizen-Candidate Model in a simple framework with many large constituencies, many policy dimensions, and endogenous coalition formation. A model is simulated in which districts elect representatives who themselves interact to form parties. Competition between parties of different sizes and with different platforms is an emergent property of the model which leads to stable equilibria. The paper shows that the widespread usage of the Citizen-Candidate
model may be empirically justified. Our results demonstrate how the number of policy dimensions and representatives elected per electoral district influence the number, size, and relative locations of parties and consequently the possible stable equilibria. Comparison with election data shows strong correspondence between the model’s results and observed outcomes, including variation consistent with Duverger’s law.
The African Credit Trap*
(file size: 232K, last updated: 05/2010)
Abstract. We put forward a plausible explanation of African financial underdevelopment in the form of a bad credit market equilibrium. Utilising an appropriately modified IO model of banking, we show that the root of the problem could be unchecked moral hazard (strategic loan defaults) or adverse selection (a lack of good projects). We provide empirical evidence from a large panel of African banks which suggests that loan defaults are a major factor inhibiting bank lending when the quality of regulation is poor. We also find that once a threshold level of regulatory quality has been reached, improvements in the default rate or regulatory quality do not matter, providing support for our theoretical predictions.
R&D Subsidies, Spillovers and Privatization in Mixed Markets
(file size: 260K, last updated: 07/2010)
We examine the use of subsidies to R&D in a mixed and a private duopoly market. We show that the socially optimal R&D subsidy is increasing in the degree of spillovers but it is lower in the private duopoly. The optimal R&D subsidy leads to an increase in total R&D and production, however, it does not lead to the equalisation of per firm output and therefore to an efficient distribution of production costs. We also find that privatization of the public firm reduces R&D activity and welfare in the duopoly market. This result stands even when optimal R&D subsidies are provided.