Framing effects and loss aversion in labour supply responses to work disincentives: Is there an endowment effect?

Background

Out-of-work benefits have often been criticised as discouraging work and trapping low-income families in a life on benefits. Previous research has shown that individuals tend to reduce their labour supply in the face of out-of work benefits, both because of the available income and especially because this income is lost once starting to work.

Using insights from psychology and behavioural economics, the project further investigates how individuals react to changes in both out of work benefits and taxes.
The study uses the ‘endowment effect’, a phenomenon which indicates that individuals value more an object once they own it, to shed new light on the mechanisms through which taxes and benefits influence willingness to work.

The implication of the application of the endowment effect in the tax-benefit area is that labour supply disincentive effects may be larger when they stem from benefit withdrawal compared with income taxes.

Benefit withdrawal is potentially much more likely to be perceived as a loss compared with income taxation, a loss of future rather than already realised income. This in turn implies that individuals will be more likely to reduce their labour supply in the face of benefit withdrawal e.g. to avoid the loss of benefits, compared to direct taxation.

Project aims

This project aims to:

• investigate the applicability of the “endowment effect” to labour supply responses in the face of different forms of taxation

• test whether labour supply responses are likely to be larger in the case of benefit withdrawal compared to direct income taxation

• measure the attitudes of survey respondents to risk aversion and loss aversion within the context of the experiment and establish links between loss aversion and labour supply behaviour

Data sources and methods

The project involves carrying out an experiment to compare the magnitude of labour supply responses in the face of taxation and benefit withdrawal. Participants are drawn from the student body at the University of Essex who have registered their interest in taking part in EssexLab experiments.

The experiment is designed to reproduce in the lab a simplified version of optimisation under budget constraint problems involving labour supply. To approximate labour supply, subjects are asked to perform a simple, repetitive task-in this case folding letters and putting them in envelopes. They are then paid according to the number of letters they fold.

All subjects are paid a fixed-fee for participating in the experiment. The experiment has a purely between-group design, where each subject is randomly allocated to one of three groups:

• Group 1 is paid a gross piece-rate for every folded letter but must pay back taxes from its earnings (taxation).

• Group 2 is also paid a gross piece-rate for every letter folded but for each folded letter must pay back some of its show-up fee (benefit withdrawal).

• Group 3 is paid a gross piece rate that is equal to the net rate in the case of the other two groups. It pays no taxes and loses no benefits (baseline).

At the end of the experiment respondents complete a questionnaire to gather information on attitudes towards risk aversion and loss aversion.