Have you ever been on vacation and found yourself uncharacteristically splurging on a restaurant’s second most expensive bottle of wine? If the answer is yes, you may have been a victim (or beneficiary) of mental accounting.
Money is fungible, which means that every dollar has the same value—that any cent is the same as any other—but we don't always act as if that's the case. A dollar spent on vacation might belong to a mental “vacation” account, and so it doesn’t elicit the same scrutiny as a dollar spent on a typical Tuesday afternoon.
Our current understanding of mental accounting is most often associated with the work of Richard Thaler, the University of Chicago economist and co-author of Nudge. But the most famous manifestation of mental accounting comes from an experiment conducted by behavioral economics patriarchs Amos Tversky and Daniel Kahneman that they discuss in a 1981 paper in Science (PDF). It’s the kind of experiment that litters Kahneman’s recent best-seller, Thinking Fast and Slow.
In the experiment, participants were told to imagine arriving at a movie theater and discovering that they had lost either a $10 ticket or a $10 bill. They were then asked whether they wanted to buy a (second) $10 movie ticket. Participants who were asked to imagine they lost the ticket were less likely than those who imagined they lost the money to say yes (46 percent versus 88 percent) even though the two scenarios were equivalent: Each person was asked to spend $10 after losing $10. The difference was that participants who lost the ticket had already spent the $10 in their mental "movie” account, and it couldn’t be replenished.
Even if individuals draw some emotional benefit by saving inheritance money, from a social standpoint it's better if people—and wealthy people in particular—spend their money on durable goods or semi-risky investments.
The use of money isn’t the only thing that can lead to mental accounting. People also treat money differently based on where it comes from. A recent study by Cornell psychologists Chelsea Helion and Thomas Gilovich found that people are more likely to buy hedonic rather than utilitarian items if they make a purchase using a gift card. It would seem that being labeled as a gift allows money to be spent in unique ways.
THE CONNECTION BETWEEN MENTAL accounting and individual decisions is clear and established, but research is increasingly highlighting new ways that mental accounting is relevant to public policy, and tax policy in particular.
A new National Bureau of Economic Research paper by Dayanand Manoli of the University of Texas and Nicholas Turner of the U.S. Treasury suggests that a person’s mental accounting with regard to a tax refund can affect college enrollment. Manoli and Turner found that when families with a high school senior received an additional $1,000 in tax refund payments it increased college enrollment rates by two to three percentage points. But the effect of an additional $1,000 in refund payments during a student’s junior year was negligible.
One way to interpret the findings is that when a student is a senior, and months rather than years from graduation day, their parents are more likely to mentally place the additional money in a mental "college” account rather than something like a “new car” or “bills” account. Because it’s the timing of the money that matters most, you don’t even have to spend the full $1,000 per family to generate the desired benefits.
Imagine if the government offered to pay low-income families with a junior in high school $250 to defer $1,000 in refund payments for one year. Now you get most of the benefits, but the program only costs $250 per family. Alternatively, you could create a system that allows families with a senior to pull a future refund into the present. The idea would be to raise college enrollment by shifting when people get various tax refunds without making significant changes to the overall return.
A new study by Orit Tykosinski of the Interdisciplinary Center in Herzliya and Thane Pittman of Colby College also has policy implications. Their study is based on the hypothesis that inheritance from a beloved relative might feel endowed by the relative’s essence or legacy, and this would increase the desire to preserve the money.
To test this idea, Tykosinski and Pittman conducted a series of four experiments in which participants decided how to spend money that came from different sources. In the first experiment participants had three bank accounts, each with an equivalent sum of money from a different source—a summer job, a birthday present, or an inheritance from a grandmother. Participants were asked how they would purchase one of two items, textbooks for school or a weekend at a resort.
The imagined origin of the money influenced how participants chose to spend it. As predicted, participants were less likely to spend the inheritance money on either purchase. Participants who did choose to spend the inheritance money were less likely to spend it on the resort compared to money from the other accounts.
Three follow-up experiments by Tykosinski and Pittman exploring how the relationship with a relative influences how an inheritance is spent supported their initial findings. The researchers found that participants who received an inheritance from a beloved—rather than an unknown—relative were less likely to put it into high-risk stocks; participants were more likely to spend the money in a way that aligns with the deceased relative’s values; and participants were less likely to spend the inheritance money if they had a positive relationship with the relative.
Even if individuals draw some emotional benefit by saving inheritance money, from a social standpoint it's better if people—and wealthy people in particular—spend their money on durable goods or semi-risky investments. Buying a blender or funding a start-up does more to stimulate the economy than leaving your money in a low-risk mutual fund.
It seems that the tendency to save inheritance money is another reason to support a higher estate tax. If mental accounting is preventing inheritance money from being spent in the most efficient way, that strengthens the case for raising estate tax revenues to fund welfare programs (and if you lean right and cringe at that word choice, just replace “welfare programs” with “other tax breaks for the wealthy that are more stimulative.”)
The relationship between tax policy and mental accounting is nothing new. The Obama administration famously designed tax cuts in the stimulus bill to be dispersed by withholding less money in regularly scheduled paychecks rather than by mailing out supplementary checks. The belief was that people would be less likely to save the money if they didn’t see it as something separate. We’ll never know exactly how effective it was, but even if it did increase consumer spending it was considered a political disaster because it kept citizens from learning how they benefitted from the stimulus.
It's difficult to talk about taking an already inscrutable tax code and making a bunch of tweaks based on psychological research, but at some point in the not-too-distant future we’ll need to revamp our tax system. When that time comes it would be wise to have a few decision-making researchers in the room.