People respond to incentives

Hal Varian, writing on the Economic Scene (NY Times), thinks about how to improve the incentives for people to save.

One promising proposal has been to set defaults for enrollment in 401(k) plans so that employees are automatically enrolled in an appropriate plan unless they explicitly choose otherwise. Brigitte C. Madrian, an economist at the University of Pennsylvania, and Dennis F. Shea, from the UnitedHealth Group, have found that this simple policy increases participation rates dramatically.

Another suggestion is to provide matching grants to low-income individuals. Esther Duflo of M.I.T., William G. Gale and Peter Orszag of the Brookings Institution, Jeffrey B. Liebman of Harvard and Emmanuel Saez of the University of California, Berkeley, recently released a working paper examining the design of such a plan. ("Saving Incentives for Low- and Middle-Income Families: Evidence From a Field Experiment With H&R Block"; a nontechnical summary is available at http://www.nber.org/digest/may06/w11680.html.)

In this experiment, about 14,000 low- and middle-income families in the St. Louis area were offered a 20 percent match on their contributions to an I.R.A., a 50 percent match or no match at all. Individuals could make a direct contribution or allocate part of their tax refund to an Express I.R.A. account offered by H&R Block.

Only 3 percent of the individuals who had no match — the control group — contributed to an I.R.A. But 8 percent of those with a 20 percent match rate contributed, and 14 percent of those with a 50 percent match contributed. The amount contributed was four times as much as the control group for the 20 percent match rate and seven times as much for the 50 percent match rate.

The first option is a bit of an admission that people aren't always perfect rational optimizers (see also this post). I have no problem with it as long as people always have the option to change. For one reason or another, a lot of people never move off the default settings, so be sensible about setting the defaults. Good advice for software design and for policy.

The second option is the sort of thing you'd expect an economist to suggest. Are the policymakers listening?

As they say, read the whole thing.

UPDATE: Mark Thoma wishes that Varian would identify the specific market failure that necessitates government intervention. Part of it might, in fact, be myopia on the part of savers (a behavioral issue rather than a market failure). Brad DeLong once said as much. Surely this wouldn't be the only example of a government intervention meant to change behavior rather than correct market failure. (Not all such interventions are agreeable to me, but I'd give this the benefit of the doubt.) Furthermore, I would add that government intervention for a good reason to correct a market failure such as moral hazard and provide a social insurance program may have some negative effects on incentives to save. Again, I refer to Brad DeLong's posts (such as this one) where he not only addresses the need to increase savings in the context of the Social Security debate but also recommends making it the default option to put your tax refund into a savings plan (which is similar in spirit to the first option in Varian's article). I really do think that part of the problem of low savings is that we have an imperfect solution to a fundamental market failure and the low personal savings rate, especially among low and middle income Americans is one of the side effects. So while I like the ideas Varian describes and would like to implement them, we probably could do something better than adding epicycles on epicycles.