Reframing the Climate Debate

The Climate debate has proven to be a diabolical policy problem for politicians in Australia, a country with one of the highest carbon dioxide emissions per capita in the world having an economy heavily dependent on the export of coal and other carbon intensive commodities.

It was partly responsible for the sacking of a once popular PM by members of his own party during his first term. It was dragging down the popularity of the lady that replaced him. Even a coalition between the Greens, Labor and a few independents representing country-based electorates could not provide a consensus in the debate.

Then came the proposal of an economist to offset a carbon tax with an income tax cut. The idea is hardly new. Even the Prophet of an Inconvenient Truth advised the scrapping of payroll taxes in lieu of a carbon tax a few years ago. The idea was to lighten the burden of productive activity (labor) while increasing it for environmentally destructive ones (pollution).

The advocacy of this tax cut approach as part of an overall principle of making the polluter pay while compensating vulnerable members of the community has stemmed the bleeding of support as expressed in the poll numbers and restored this government's legitimacy at least for now.

The re-framing of the debate is something that has eluded previous proposals for a carbon pollution reduction scheme. The use of a tax to price carbon rather than a synthetic market (read: emissions trading scheme) is much simpler and straight-forward. It also avoids much of the costly transactions costs involved in setting a complex trading system.

The use of tax cuts to offset additional living costs on households to whom polluting energy firms would pass on any tax burden does away with the notion that the "little man" would be the hardest hit by the tax. It also reduces the disincentive to work without creating budget pressures.

Indeed the Opposition will wish that it had proposed the Carbon tax with the accompanying income tax cuts ahead of the government as what a conservative think tank had earlier done. Having been outflanked by Labor on this issue, it now has to reconcile its carbon abatement policies which opts to use government regulation rather than a market mechanism something that economic liberals are not known for. Being the party that invented "middle class welfare" it will now find it difficult to counteract the middle and lower income tax cuts now being considered.

Classic Under-Investment

A work colleague of mine recently raised a question about why so many young people opt out of school early and never pursue any further education afterwards. For them, any sort of economic reward or incentive to invest in them just won’t be met with enthusiasm. “Why then should governments waste taxpayer’s money encouraging them to do so?” she asked.

It is a classic under-investment problem, I answered, involving the accumulation of human capital where despite the provision of services, an underwhelming take-up rate on the part of students is the response. Of course the irony is that in the developing world, there is no shortage of people that would be interested in training that would lead to better employment outcomes. For example, in this published paper that I wrote back in 2007, I found that the college participation rates in the Philippines were the same as in Australia, despite a lower proportion of GDP dollars being publicly spent there on tertiary education.

Society is worse off if the potential productivity and availability of skills is not realized due to this under-investment in human capital. So back to the original question, should the government spend greater effort in encouraging a larger proportion of young people to remain either in school or post-school education for longer if they apparently do not seem all too keen?

In answering that, it is best to examine the way we frame the problem first. The traditional approach is based on a rational interpretation of human behaviour, in which the choice of the individual must be respected at all costs, in that only he or she can determine what is best for him or her, and if that means less schooling, then so be it. An alternative based on a behavioural perspective however provides a different set of lenses to appreciate the problem more fully. From this perspective, there are several reasons why individuals may behave irrationally.

The first is that humans tend to over-estimate their abilities. This overconfidence leads them to settle for a sub-optimal level of schooling. Youths with an artistic bent might drop out of school believing they can successfully break out in creative careers. Teen couples do so believing too much in their ability to conquer the difficulties of raising a family. Others who are delinquent believe in their ability to lead a lifestyle outside the law. You get the picture.

The second reason is that humans have a present-bias. Meaning, time has a way of distorting decisions that involve the weighing of costs and benefits, especially when costs have to be borne in the near term for some future benefit. Like the problem of saving for retirement or improving one’s health and fitness, under-investment in education and training is the result of people putting more importance to the present to the detriment of the future.

The third reason is the commitment problem. Even when individuals decide to undertake training, they often fail to follow through with their commitment. The phenomenon of starting but never finishing--call it “buyer’s regret”, “cognitive dissonance” or the lack of persistence; individuals face an uphill battle when it comes to sticking to their commitments particularly because of overconfidence (which in this case is the overconfidence to complete what they signed-up for) and present-bias (putting off assignments until the last minute).

Finally, there is the information problem that youths encounter when making career choices. What occupation suits them? Which one will be most rewarding? What type of course to take, and which institution to register with? These are difficult decisions to make because they are infrequently faced, so the person cannot benefit from experience (or hindsight) in making them. Even the potential for social learning or gaining advice from one’s elders who have encountered making such decisions before can be obstructed due to personal biases. 

With all these problems facing the individual, it is probably a wonder why anyone makes the right decision. It certainly provides the rationale for the state to stimulate greater demand for education and training. In this endeavour, there are two possibilities. The state can deal with either the front end or the back end of the cohorts coming through. The back-end involves nudging youths of school-leaving age to persist in school through career advice and greater access to information and varied training opportunities.

The front-end means intervening in early childhood as a way of affecting values and preferences. As this study showed, good quality kindies matter in determining the long-run earning capacity of pupils. The results of such a study are quite controversial, but I think that the reason early intervention works and has a long-lasting impact has more to do with instilling a love of learning and imparting a sense of wonder about the world in kids that sticks with them throughout life and keeps them engaged in school much longer than would otherwise be the case.

A Con at BrisCon

If you were faced with two investment opportunities:

• one involving the purchase of a stock at 1/1000^th of the asking price, and
  
• the other involving the purchase of a stock with a possible future obligation to pay 2000 times the original unit value of your investment, which one would you take?

Obviously, the first one would be almost irresistible; the second would seem quite dubious to anyone. It came as a shock to many mom and pop investors that, in the case of their BrisConnections holdings, the two options were identical. As reported in the Sydney Morning Herald this week,

BrisConnections stapled units were sold in a initial public offering last July, with investors paying the first of three $1 instalments at the time.

They were then required to pay two further instalments, one this month and another in January 2010.

But many shareholders sold out of the stock after it was listed, with the units closing at 41 cents on the first day of trading.

They had plunged to 0.1 cent by October and have remained around that level ever since.

Many retail investors bought the units thinking they were getting a bargain, without realising that they would be required to pay a further $2 on each unit, making themselves liable for further payments up to 2000 times the value of their investment.

To borrow the words of Richard Thaler and Cass Sunstein, authors of the book Nudge, this is a case of poor “choice architecture”. One of the main points found in the book is that although many of us would like to think of ourselves as rational decision-makers, we are often primed to make foolish choices by of the way solutions are framed.

As behavioural economists point out we are (aside from being rational beings) subject to human frailties that our reasoning often gets confounded by complexity. What a layperson perceives as a perfectly reasonable choice upon closer scrutiny often turns out to be misinformed. Discounting this very nature of our thought processes may lead to a poor design of “nudges” or the prompts that are aligned to the way our brains are wired preventing us from perceiving a situation correctly.

In the case of BrisConnections, investors thought they were buying into a project which had a compelling business case with an implicit state guarantee at a huge discount. They failed to assess the risk of contingent liabilities. Yes there were public disclosures but most do not read the fine print when accepting an offer is only a mouse click away. Following Nudge principles, a simple prompt after the person has pressed “accept” warning them of the possible value of their contingent obligations would have alerted many to the dangers of proceeding.