Prospect Theory and Progressive Income Taxes

"I don't like losses, sport. Nothing ruins my day more than losses."
--Gordon Gekko (Wall Street)

An important contribution of prospect theory (Kahneman & Tversky, 1979) is the concept of loss aversion. Generally speaking, losses feel more than gains feel good. As such, people will often go to great lengths to avoid or recover from losses.

Loss aversion classically applies to investing and risk management. A 10% decline in a portfolio position stings more than a 10% increase soothes. Investors may dislike the feeling of a losing position so much that they 'double down' on their gamble in hopes that the position will quickly return to 'break even.'

As successful gamblers well understand, a general habit of adding more to losing positions is likely to land you in the poor house sooner or later. As such, the implications of loss aversion on general capacity to invest and hold onto wealth are somewhat ominous...

A tangential application of loss aversion relates to progressive income taxes. Since their advent over a century ago, progressive income tax schemes have typically been justified by 'ability to pay' doctrine. People who earn more income seen as having more discretionary income that can be spared for tax purposes.

When high earners balk at paying higher rates, proponents of progressive income taxes are quick to chastise. "Why should they complain about paying more? They're still making a ton."

But from the high earners' standpoint, they are losing instead of making. While a 40% marginal rate means that a high earner still keeps $600,000 on a million dollars in marginal income, that earner is apt to see it as a $400,000 loss. As such, that earner may go to considerable lengths (e.g., support anti-tax lobbies, tax shelters, off shore accounts, maybe even dial back on production) to mitigate those losses.

Ironically, many of those high earners voluntarily give away large portions of wealth to charity. These donations are likely viewed as gains, perhaps in the form of psychic income, rather than losses.

Reference

Kahneman, D. & Tversky, A. 1979. Prospect theory: An analysis of decision under risk. Econometrica, 47: 263-291.