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The Experimenter

From the September/October 2007 Issue

At 28, Berkeley economist Raj Chetty aligns theories with real-world facts, leading him to surprising conclusions on taxes, investing, and welfare.

ChettyRaj Chetty, now 28, was a sophomore at Harvard University when he came up with the theory that higher interest rates sometimes lead to higher investment. It was a counterintuitive idea. Usually, companies invest less when rates rise because the higher rates increase the cost of capital. But Chetty found that some companies, in fact, invest more because they want to get revenue-generating projects off the ground sooner, rather than later, in order to pay down that costly capital more quickly.

That idea was so compelling that economist Martin Feldstein, who had been using Chetty to help with his own research, told him instead to go off and pursue his own ideas. “A professor likes nothing better than to have a brilliant research assistant,” says Feldstein, a Harvard professor who served as chairman of the Council of Economic Advisers under President Reagan and is CE O of the prestigious National Bureau of Economic Research. “But I realized Raj was quite unusual. His sophistication and ability to work through problems were just higher than even the best of undergraduates at Harvard.”

Chetty, who remained at Harvard for his Ph.D., became an assistant professor of economics at the University of California, Berkeley, at 23 and became a tenured associate professor at 27. Like others chosen by THE AMERICAN for the Young Economist column, he likes to put received economic wisdom to the empirical test.

“He combines a clean understanding of economic theory with a great interest in data and the real world,” says James Poterba, chairman of MIT’s economics department. Poterba, who recently served as a member of the President’s Advisory Panel on Federal Tax Reform, cites Chetty’s work on how corporations responded to a cut in dividend taxes. For 25 years, economists have debated how U.S. corporations would react, and when the rate was cut from a high of 35 percent to 15 percent in 2003, Chetty and his collaborator, Emmanuel Saez, were the first to analyze the data and look for changes, Poterba says.

In their study, “Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut,” published in The Quarterly Journal of Economics in 2005, Chetty and Saez found not only that more companies paid out dividends after rates were lowered, but also that they were likelier to pay dividends if top executives had substantial shareholdings in the firm.

The study found that efficiency suffers when the dividend tax rate is too high—or when top executives own too few shares. Those factors can drive a wedge between the interests of CE Os and shareholders, encouraging managements to reinvest earnings in lower-priority projects or frivolous purchases, like a nonessential corporate jet or a plush office. When rates were higher, Chetty says, executives “had a stronger incentive to keep that money within the firm and get that private jet, instead of paying it out in the form…of dividend income.”

One of his studies found that high dividend tax rates can drive a wedge between the interests of CEOs and shareholders, encouraging CEOs to reinvest earnings in lower-priority projects or frivolous purchases.

While his study on dividend taxes was influential, Chetty hopes to have his greatest impact in another area: social programs that help cushion risk. In a study entitled “Consumption Commitments and Risk Preferences,” published this year in The Quarterly Journal of Economics, Chetty and Berkeley colleague Adam Szeidl contest the popular belief among economists that unemployment insurance is too generous. George Akerlof, who also teaches at Berkeley and won the Nobel Prize for Economics in 2001, describes Chetty’s insight in the study as revolutionary. “He had a new way of looking at the problems of the unemployed,” Akerlof says. “Raj emphasized that they find it very difficult to meet their prior commitments. For example, they must pay their rent or their mortgage, and these commitments very much add to the difficulties of being unemployed. Economists were just not thinking of that until Raj came up with it. This is a very big innovation in the theory of unemployment.”

Chetty believes that if he can bring models and theories into better alignment with real-world evidence, he will help shape economic policy. It’s an ambition that runs in the family: his father, V. K. Chetty, was an economic adviser to Indian Prime Minister Indira Gandhi in the 1980s, helping her privatize the government-run cement industry as India’s economy began to make the transition from socialism to free-market capitalism.

Chetty is drawn to the psychological underpinnings of economic theory. Before deciding on a change to the tax code, he argues, politicians should study how consumers think about taxes. With that in mind, he created an experiment to determine whether separately labeling the sales tax on an item would affect a shopper’s behavior. He persuaded a large grocery chain to allow him to post tags next to 750 of their products for three weeks, showing how much the item would cost after sales tax was added. Fearing the experiment would result in lower sales, the chain did not allow Chetty to post signs on its most popular items.

Chetty 'had a new way of looking at the problems of the unemployed,' says economist George Akerlof, who won the Nobel Prize in 2001. 'This is a very big innovation.'

The store management’s fears were well founded. When consumers knew just how much more taxes would cost them, they reduced their purchases of the items by about 7 percent. As part of the working paper—titled “Salience and Taxation: Theory and Evidence,” coauthored by Adam Looney of the Federal Reserve Board and Kory Kroft of Berkeley’s economics department—Chetty surveyed customers entering the store to determine whether they knew which goods were taxed and which ones weren’t. They were generally able to distinguish the two categories. In other words, they knew that an item was taxable, but actually seeing the total cost—including the tax—at the time of a potential purchase discouraged them from buying it.

“It may not sound unusual. But in economics, most people don’t do experiments. They’re happy to take the data as they find it. They don’t create novel experiments to understand the way the world works,” Feldstein says. “It was a very ingenious way of showing how taxes actually affect shopping behavior—that people actually shopped less when they recognized the full cost of what they were doing.”

Given that consumers seem to weigh taxes more heavily when they are reminded of the burden, Chetty wondered whether Americans understand the implications of the Earned Income Tax Credit, a program meant to motivate low-income people to work by subsidizing their wages. Enacted in 1975, the program was expanded in 1986, 1990, 1993, and 2001. It is considered one of the government’s central anti-poverty policies. Under the program, those who earn, say, $10,000 a year might be given a credit once a year for $4,000, or 40 percent of their salary. But after surveying some of the beneficiaries of the EITC , Chetty found that most people who get it don’t understand how it works.

“They just know that after they file their taxes, they get a big check,” Chetty said. “That is seriously problematic for public policy, because the whole point of the program is to give people an incentive to work. To give them an incentive to work, they really need to understand that they’re really being paid $14 an hour, not $10 an hour.”

The U.S. government spends over $1 trillion—about 40 percent of its annual budget—on social insurance programs that affect the lives of millions of people. Much of that money gets spent without the help of market forces to ensure that the funds are efficiently allocated. At a time when higher-income earners are pulling farther ahead of other Americans, Chetty says that it is even more critical that social programs deliver the greatest possible benefits to the poor. The stakes are high. “By changing policies, the government can drastically alter the trajectory of a whole nation’s welfare.”

This is the third Young Economist column for Caren Chesler, a writer who lives in New York.

 

Image credit: photograph by Fran Collin.

 

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