Optimal Distribution Of Powers In A Federation: A Simple, Unified Framework

In a federation with n ≥ 2 regions the relative optimality of six regimes- autarky, centralization, unregulated devolution, regulated devolution, direct democracy, and revenue maximising leviathan, is examined. Public policy consists of redistribution and regional public good provision. Regional incomes are uncertain and correlated while estimates of the usefulness of regional public goods are uncertain; the federal government’s estimates are noisier relative to those of regional governments. The optimality of each regime is influenced by four margins- regional insurance, coarseness of federal information, internalisation of spillovers and ‘raiding the commons’. Regulated devolution is the only regime that is capable of producing the constrained first best level of public goods. Federal insurance under the two regimes of direct democracy and a federal leviathan, can be inadequate relative to that under a utilitarian federal government. An increase in the number of regions has important implications for insurance and raiding the commons. The median region’s choice of redistribution under direct democracy is influenced in important ways by the distribution of regional uncertainties. The paper synthesises a significant proportion of the existing literature in a single model and also provides several new results

Book review: C. Monica Capra, Rachel T.A.Croson, Mary L. Rigdon, and Tanya S. Rosenblat, eds. (2020) The Handbook of Experi-mental Game Theory. Edward Elgar Publishing Limited

Book review: C. Monica Capra, Rachel T.A.Croson, Mary L. Rigdon, and Tanya S. Rosenblat, eds. (2020) The Handbook of Experi-mental Game Theory. Edward Elgar Publishing Limite

A note on generalized hyperbolic discounting

In a major contributions to behavioral economics, Loewenstein and Prelec (1992) set the foundations for the behavioral approach to decision making over time and derive the generalized hyperbolic discounting formula. Here we show that their assumption ‘common difference effect with quadratic delay’ cannot be weakened to ‘common difference effect

Increasing elasticity of the value function in the Loewenstein-Prelec Theory of intertemporal choice

In a critique of the Loewenstein and Prelec (1992) theory of intertemporal choice, al-Nowaihi and Dhami (2006) point out to four errors. One of the alleged errors was that the value function in prospect theory is decreasing. But it is in fact increasing. We provide a correction and a formal proof. As a corollary, we show that the elasticity of the value function is bounded between zero and one. Nevertheless, all the remaining points in al-Nowaihi and Dhami (2006) remain valid

Why Do People Pay Taxes? An Explanation Based On Loss Aversion And Overweighting of Low Probabilities

Given actual probabilities of audit and penalty rates observed in the real world, tax evasion should be an extremely attractive gamble to an expected utility maximizer. However, in practice, one observes too much compliance relative to the predictions of expected utility. This paper considers an alternative theoretical model that is based on Kahneman and Tversky's cumulative prospect theory. The model predicts empirically plausible magnitudes of tax evasion despite low audit probabilities and penalty rates. An increase in the tax rate leads to an increase in the amount evaded- a result, which is both, intuitive, and factual, but is contrary to the prediction made by expected utility theory. Furthermore, the optimal tax rates predicted by prospect theory, in the presence of tax evasion behaviour, are consistent with actual tax rates

Mental Accounting, Loss Aversion, and Tax Evasion: Theory and Evidence

The evidence shows source-dependent entitlement to income sources and individuals arereluctant to part with income they feel more entitled to, e.g., earned labor income. Taxpayersmay also be more reluctant to part with tax payments (evade more) from income sources theyfeel more entitled to- a form of mental accounting. We embed two main hypotheses within arigorous theoretical model based on prospect theory. From incomes sources they feel moreentitled to, taxpayers experience (i) greater loss aversion from paying taxes, and (ii) lower moralcosts of evasion. We confirm the predictions of our model through MTurk experiments. Evasionis increasing in the tax rate and decreasing in the audit penalty. Moral costs influence taxpayers’decisions. Loss aversion, measured “directly” for the first time for each individual in an evasionexperiment, reduces evasion, as predicted by our theory. Loss aversion, risk aversion, and theirinteraction, are critical determinants of evasion.</div

Non-Linearities, Large Forecasters And Evidential Reasoning Under Rational Expectations

Rational expectations is typically taken to mean that, conditional on the information set and the relevant economic theory, the expectation formed by an economic agent should be equal to its mathematical expectation. This is correct only when actual inflation is “linear” in the aggregate inflationary expectation or if it is non-linear then forecasters are “small” and use “causal reasoning”. We show that if actual inflation is non-linear in expected inflation and (1) there are “large” forecasters, or, (2) small/ large forecasters who use “evidential reasoning”, then the optimal forecast does not equal the mathematical expectation of the variable being forecast. We also show that when actual inflation is non-linear in aggregate inflation there might be no solution if one identifies rational expectations with equating the expectations to the mathematical average, while there is a solution using the “correct” forecasting rule under rational expectations. Furthermore, results suggest that published forecasts of inflation may be systematically different from the statistical averages of actual inflation and output, on average, need not equal the natural rate. The paper has fundamental implications for macroeconomic forecasting and policy, testing the assumptions and implications of market efficiency and for rational expectations in general

Discounting by intervals: An inconsistent theory of intertemporal choice?

We show that the theory developed in Scholten and Read (2006) "Discounting by Intervals: A Generalized Model of Intertemporal Choice", Management Science, 52, 1424-1436, is an inconsistent theory. We suggest a way the inconsistency can be removed

Rebuttal of Hashimzade, Myles and Tran-Nam (2009) "New approaches to the economics of tax evasion

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

The Behavioral Economics of Insurance

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