Does our "loss aversion" explain enthusiasm for a graduate tax?by Richard Holton / February 20, 2004 / Leave a comment
Published in February 2004 issue of Prospect Magazine
It is an axiom of economics that people would rather have more than less. Yet people often behave in a way that defies the axioms of economics. A new branch of social science is devoted to explaining why people arrange their preferences in an apparently irrational way. The new approach is called “prospect theory.” The key idea, in the words of Daniel Kahneman, who shared the Nobel prize in economics in 2002, is that losses loom larger than gains. Prospect theory may explain why many people seem to find a “graduate tax” more acceptable than “top-up fees,” even if the tax would involve higher payments; fees look like a loss imposed on the student, whereas a tax does not. The people who say most vehemently that a tax would be more acceptable than fees are often those who are most anxious to ensure that the government’s plans do not deter working-class students from applying to university. On the face of it, this defies economic logic. Under the government’s proposals, top-up fees will be repayable, at a zero real rate of interest, until the liability is paid off. Repayment would only start when the graduate is earning ?15,000 a year, and would cease if income fell below this level. As many people have pointed out, this is the best bargain that students are ever likely to get. Its terms beat mortgage repayments and credit card debt hollow. By contrast, a graduate tax would be levied on all new graduates for as long as they were above some minimum income threshold. This threshold is likely to be much the same as that envisaged for repayment under the top-up fees plan; and the level of receipts required will not be less than that required to pay off the top-up fee loan, even if the rate in the pound to the taxpayer is less. But there is a big difference: at some point the top-up loan will be paid off, at which point payments will cease; whereas under the tax scheme, payments will continue for as long as the individual goes on earning more than the threshold. For anyone, but most of all for the risk-averse working-class student who is the focus of so much discussion, there should be a preference for the top-up loan. Surely you would rather pay off a limited liability than an unlimited one. Clearly many do not think like this. Why not? This is where prospect theory comes in. Its first lesson is that people are not mainly concerned with absolute levels of wealth; rather, they are concerned with gains and losses relative to their status quo. In particular, people are acutely sensitive to losing what they already have. They are much more upset by a loss than pleased by a corresponding gain. Once we think of something as ours, our attitude towards it changes. In an experiment, when asked how much they would pay for a souvenir mug, people’s answers averaged around $2.50. But when given such a mug and asked how much they would sell it for, answers averaged around $5. The effect appears to be very general. Once we get to a certain level of income, or of wealth, we become concerned about losing it. In the terms of prospect theory, we are “loss averse.” This focus on avoiding loss rather than achieving gain brings a different attitude to risk, depending on whether losses or gains are in the picture. Faced with the choice of a certain gain of $3,000 or an 80 per cent chance of gaining $4,000, most people go for the smaller certain gain. However, with losses the situation is reversed: most people would rather risk an 80 per cent chance of losing $4,000 than accept the certainty of losing $3,000. This shows, as Kahneman and Amos Tversky wrote in their Nobel-cited article in 1979, that “risk aversion in the positive domain is accompanied by risk-seeking in the negative domain.” When it comes to gains, people would rather have a smaller amount for sure than the chance of getting a larger amount. But when it comes to losses, people would rather risk losing a larger amount than losing a smaller amount for sure. Prospect theory also teaches us that it is very important how things are framed. If something can be presented as a failure to gain, rather than as a loss, people will be happier. That is why retailers typically talk in terms of a discount for cash, rather than a surcharge for credit cards. We suspect that both loss aversion and framing effects are at work in the current debate on university funding. Even though fees and taxes impose much the same kind of liability, though for different durations, they look very different. Fees look like a loss imposed upon the student. Moreover, they look like a certain loss: it is sure that the student has the debt, even if it only has to be repaid once income passes a given level. In contrast, a tax doesn’t look like a loss at all. To become liable to a tax is simply to reduce one’s possible future gains. And having to pay the tax is only a possible (albeit likely) outcome; it is not certain, in the way that incurring the debt appears to be. How should the government respond? It should commission focus group research to see whether our hypothesis is supported. It should also try to explain the illusion along the lines offered here. The literature suggests that people are responsive to such explanations, but it is an uphill struggle. The alternative is to change the framing. The government has wrongfooted itself by talking, about “top-up fees” and “student debt.” It should frame what it is proposing as a “graduate tax” – but a fixed-term tax, not a lifetime tax. Once framed in that light, people may see that it is in their interest to pay less rather than more.