Why companies invest more when interests are high October 12, 2007 Raj Chetty was educated

at Harvard, where he received his PhD in 2003; the same year he became an assistant professor at Berkeley at age 23. He was promoted to associate professor in 2007. George Akerlof, the Berkeley professor who won the Nobel Prize for Economics in 2001, describes Dr Chetty's work in the area of une mployment as 'revolutionary' and a very big innovation in the theory of unemploy ment.' Dr Chetty won the 2005 Smith Richardson Public Policy Research Fellowship and ha s received three multi-year National Science Foundation grants, including, most recently, a Career Grant in 2006. Dr Chetty was a sophomore at Harvard when he c ame up with the theory that higher interest rates sometimes lead to higher inves tment. According to conventional wisdom firms invest less when rates rise becaus e the higher rates increase the cost of capital. But he discovered some companie s invest more because they want to get revenue-generating projects off the groun d sooner so that they can recoup the investment. '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 idea,' according to The American magazine which ran a story recently on Pro fessor Chetty. It was called The Experimenter, referring to the experiments he c onducts. 'A professor likes nothing better than to have a brilliant research ass istant,' says Feldstein.' But I realised Raj was quite unusual. His sophisticati on and ability to work through problems were just higher than even the best of u ndergraduates at Harvard.' You became a professor at Berkeley when you were 23... Many people wondered if I was a student or a professor, but one of the things th at is great about academics is that it is almost purely merit-based. It does not matter how you look, how you dress, or how you act. Once you establish that you are an expert in your subject and have good ideas, you immediately earn people' s respect. Youth is to some extent viewed favorably (unlike in other professions that have a strict ladder system) since breakthrough discoveries are often made when people are young. My colleagues treated me like anyone else in the departm ent as soon as I arrived at Berkeley, even though most of the graduate students in the department were older than me. With the students, I tried to take advantage of the fact that I was roughly the same age as them to make it easier to approach the professor. In one of my class es, my teaching assistant (a graduate student) and I started the class with a pr actical joke. She began the first lecture and pretended to be the professor. I s at in the back, dressed informally like the other students. I started raising se veral questions once she started the lecture, eventually asking whether she was really qualified to teach the class. I then suggested that perhaps I should teac h the class myself. The students were quite surprised that one of their peers wo uld be so brash. She said, "Sure, why don't you give it a try?" I got up and beg an teaching. The students figured it out and enjoyed the joke. It was particular ly funny because one of the students asked me while I was sitting in the back if I knew whether this professor was supposed to be hard How did your interest in economics originate? I was interested in research and science, partly because I was exposed to it fro m my family, everyone being a PhD or MD and involved in research to some extent. I was born in New Delhi, where my father [V K Chetty] was at ISI [the Indian Sta

ndards Institute] and my mother [Anbukili Chetty] was a pediatric pulmonologist at AIIMS [the All-India Institute of Medical Sciences]. We moved to the US when I was 9 and I grew up mainly in Milwaukee. When I was in high school, I thought I would follow in my elder sisters' footsteps and be a scientist. I worked in a microbiology lab for two years in high school and published a paper in electron microscopy staining techniques. But after some time, I decided that I was better at thinking about conceptual pr oblems than doing lab work. I had always been interested in doing something I fe lt would have a big impact on human welfare. I knew a little about economics fro m my father, and it struck me as a good way to combine my interest in math and m ore technical research areas - thinking about how to tackle hard problems such a s poverty and growth to have a big impact on society. I wasn't sure exactly what I'd pursue at Harvard, but decided to take an interme diate microeconomics course my first semester. It was taught by Andrew Metrick w ho is now at the Wharton School at Pennsylvania. He is a phenomenal and inspirin g teacher. A few weeks into the class, I decided that I really liked the subject . I e-mailed several professors to try to get hands-on experience in research in economics. Martin Feldstein, one of the most senior economists at Harvard and f ormer chief economic adviser to Ronald Reagan, replied to my e-mail and hired me as a research assistant when I was a 17. I quickly got involved in the projects he was working on at the time. What fascinated me most was Feldstein's ability to go from rigorous, abstract ma thematical arguments to empirical analysis of real-world data, and ultimately to a clear, concrete policy recommendation to the government. In my sophomore year, I began to take PhD courses in economics. I found them so interesting that I completed the graduate coursework and qualifying exams the ne xt year. Soon I was writing my PhD dissertation. Why weren't you interested in pursuing a business degree? I have recently been thinking about how to get more students interested in resea rch. I think many of the brightest students nowadays choose to go to the private sector. We [Indians] have a great under-representation in many academic fields relative to other high-skilled occupations such as medicine, engineering, and bu siness. In my case, I realised that my long-term objectives lined up better with a PhD t han other paths. At a young age my dream was to discover something that would ha ve a great impact on the world and help a lot of people. I think I was very awar e of issues such as poverty and lack of growth partly because of my background, having grown up both in India and in the US. I remember, quite vividly, going to the Taj Mahal when I was eight. It was immaculate and beautiful inside. But out side, you see extreme poverty in Agra. Experiences like that sparked my interest in understanding how to improve the economy. I was fortunate to have grown up in an environment where I was well aware of wha t doing a PhD entailed and what being an academic means. My father made many theoretical contributions in economics and was very involved in government policy in India in regard to deregulation in the 1980s. I saw thr ough his work that one could have great impact by doing something that ultimatel y has some policy application, but at the same was rigorous and scientific. And I saw through my parents that the academic life could, at a personal level, be v ery satisfying and enriching.

My concern is that many bright students who would be leading scientists and rese archers choose other careers because of misinformation. In talking with non-acad emic friends, particularly those in the Indian community, I think there are two misconceptions that need to be corrected. First, one does a PhD not so much to t each but to do research that will have a big impact. Many people view professors as skilled teachers - which is one important aspect of the job - but fail to re alise that many of the fundamental discoveries in society that make our quality of life better today than in 1900 are made by academics. So I think that the soc ial value of pursuing a PhD may be underappreciated. Second, academia has the re putation of being a very tough life, particularly financially. But I think the m onetary rewards of academia are also often misperceived. This is especially true at top universities for quantitative fields, where salaries compare quite favor ably with many specialties in medicine or law. Some people ask, "Why are economi sts and scientists paid so much to sit and think?" I think of the answer one of my colleagues at Berkeley gives: 'If Milton Friedman's research helped us avoid another Great Depression, then he's paid the bill for all the economists in this generation.' Now of course not every person is going to do what Milton Friedman did... but if one out of every ten thousand does, it's worth paying researchers a lot. One of my objectives in the longer run is to try to attract more bright students to top PhD programs. For example, there's an enormous pool of talent at the IITs in India that I think could be very successful. I'd like to think abou t ways to encourage some of that group to apply to PhD programs in the US. How do you get ideas for your research, which often depart from the way economis ts traditionally think? I get a lot of my ideas talking to people casually, not economists per se; not s itting at my desk, but observing the day-to-day world - my family, my friends. I had the idea for my dissertation when I was at my sister Malathy's house in Ch icago for the Christmas break. I had been thinking about the problem of unemploy ment, and why economic theories tended to suggest that unemployment is not very costly to individuals. I began thinking about how my sister's family would react to an income shock such as job loss. What struck me when talking with my sister about their situation is that they - like other high-income professional famili es - had a lot of fixed "commitments" - expenses that they would not be able to adjust very easily in the short run if they were to suffer an income loss. For e xample, they were paying off an expensive home mortgage, paying for schooling ex penses for three children, paying for cars, etc. Losing any income would be diff icult for them despite their high level of income to begin with, because these f ixed payments left very little disposable income for items such as food. I realised that this logic was missing from the canonical theory of risk in econ omics, "expected utility theory," which effectively assumes that people can adju st consumption of all goods costlessly when they lose income. This assumption wa s the key reason that economists were under-estimating the costs of unemployment and other income shocks. Over the next three months, I worked out the mathemati cs to formalise this idea and looked at data to assess its importance in practic e. The idea led to job offers from the top universities a few months thereafter. My undergraduate thesis at Harvard (written when I was 19), concerned the effect of interest rates on business investment. I got the idea again outside the offi ce, when I was on a tour of a large Chrysler automobile plant by a friend of our family's. Most standard economic models of investment assume that you can incre ase or decrease the level of investment easily. It occurred to me that there was no way for Chrysler to do this: they could not downsize the plant easily to mak e fewer cars given the amount of fixed irreversible investment that had already been done. There was work in economics on 'irreversible investment' by Avinash D ixit and others that I read upon returning home.

I started thinking about whether irreversibility would have any implications for what happens when the government changes policies (eg taxes, interest rates). I discovered that it did. The surprising finding was that increasing the interest rate could increase investment by encouraging companies not to delay these irre versible investments. A simple example of the logic is in the introduction to my paper 'Interest Rates, Irreversibility, and Backward-Bending Investment,' later published in the Review of Economic Studies. More recently, you've been doing quite a few experiments. Tell us about your lat est work. I have been working, like most economists, on rational models where people are f ully aware of the economic environment and all the policies they face. That 'ful l information' assumption is deeply embedded in many areas of economics, especia lly public finance, my area of focus. I began getting interested in this assumption partly because of the work of my w ife, Sundari, who is doing her PhD at Berkeley in neuroscience, in particular th e effects of stress on the brain. I understand from conversations with her that the brain is sufficiently complicated that we cannot expect people to be perfect ly optimising economic agents in all environments. So, naturally, I began to que stion myself and the theoretical models I was writing: 'Does it make sense that people are fully aware of all the taxes and other government policies that they face?' Talking with non-economist friends, my sense was that many of them do not think about taxes at the level of detail the way economists that study them do. I knew that this could substantially change theories of optimal taxation, and b egan to think about a research project on this problem. The first step in challenging a longstanding assumption is to come up with clear evidence that the assumption is not correct. This led to an experiment at a gro cery store in California. If you go to a store in most states in the US, say, to buy razor blades, the price says $8.99 on the shelf. But you pay something like $9.72 at the register, because of 8 percent sales tax. We did a simple interven tion where we added a tag below the existing tag showing the tax-inclusive price , that is, total price: $8.99 + CA sales tax = $9.72. We did this for a thousand products that in categories that are very price elastic, eg cosmetics and hair care accessories. The traditional economic model would say that this interventio n should have no effect because people should already be taking the tax into acc ount. After all, we are just giving them redundant information. We found that qu antity sold did in fact fall quite substantially, by about 8 percent relative to sales in previous weeks. The implication is that most people apparently don't n ormally take the sales tax into account when making purchasing decisions. The concern with the experiment is that it may be a short-run effect, one that o ccurs only because we violate people's norms by posting these 1,000 new tags. So we tried a different strategy. Suppose I increase the price of a product by a d ollar, and I increase tax on that product by a dollar. The traditional economic theory would say that both should have the same effect because you should only c are about the price plus the tax. We test that by prediction by looking at consumption of alcohol. Alcohol is subj ect to two taxes in the US: One that is included in the price called the excise tax and one that is added at the cash register, the sales tax. Using legislated changes in these tax rates going back to 1970, we find that excise tax increases reduce demand about 10 times as much as the sales tax. The effect of sales taxe s is much smaller than excise taxes even in the long run (two or three years). Together, the two lines of evidence show that individual's responses to taxation depend quite significantly on the salience or visibility of the tax. If even th

ese simple taxes pose such problems, one must be concerned that similar effects will emerge for the much more complicated income and capital gains taxes. So now we had some evidence to challenge the longstanding assumption. The next step in the project was: What does all this mean? What are the consequences of economic policies in view of this finding? And what did you conclude? There are a few interesting results. The first is the answer you get if you ask an economist what kind of tax produces inefficiency. Normally, economists think that when you tax products it leads to inefficiency because it reduces total eco nomic output (people buying less) and growth. One of the most basic ideas if tha t if people change their behavior in response to a tax, that's a distortion and leads to an efficiency loss. Economists will tell you that if we find no link be tween the tax and people's purchasing behavior, that means there is no inefficie ncy. I've found that this logic is wrong when people don't pay attention to taxes. Th ink about it like this: Suppose you don't respond to tax because you are not pay ing attention to the tax. And suppose, say, you're spending your money on cars a nd food and there are these complicated taxes on cars, which there are actually in practice in the US. So you end up overspending on cars as opposed to what you actually thought you spent. Later on, you are consuming food and you have less money left over than you thought you would. Now you could actually end up with l ower overall utility or happiness than you would have, had you known about the t ax from the beginning and changed your behaviour accordingly. So this very basic prediction - that we should tax things where we don't see any response - 'inelastic goods' is not necessarily correct, if people are not payi ng attention to things. Essentially, you can end up reducing people's welfare th rough taxes even though they don't change their demand for the car, because they do not recognise the true cost of what they are doing. Another example is that if you ask economists whether the government should tax the company or the consumer, they will tell you that it makes no difference. The price is going to adjust and the company is going to pass the tax on to the con sumer to some extent anyway. But in the case where not everyone pays attention t o all taxes, it makes a big difference if you tax the consumer or you tax the co mpany. Say you tax the individual for a cell phone plan. The price for the cell phone plan will be quoted by the company as say $39.99, but you end up paying $4 8.00 because of the taxes that are added later. But suppose I levied the same ta xes and fees directly on the company. It would be harder for them to raise the q uoted price by $8 and pass the whole tax on to the consumer because the consumer is paying attention to the quoted price and will buy less. Whereas, if the gove rnment levies the tax on the consumer side, it's easy for the company to say to the consumer that the price you are paying is only $39.99; the tax ends up being paid completely by the inattentive consumer. So the so-called "tax neutrality r esult" - that it doesn't matter who you tax: the supply side or the demand side, the company or the consumer, does not hold. This suggests that we should think much more carefully about which side of the market we tax. Your recent work is also concerned about how government policies affect low-inco me groups. I've been studying a large program in the US that's called the Earned Income Tax Credit, on which the government spends about $40 billion per year. It is intend ed to encourage low-income people to work more by essentially subsidising their work. For every extra dollar they earn, the government gives them money. So, say , for every $10 you earn, the government gives you $4. So effectively you are ma

king $14/hour instead of $10/hour. I think the idea of this program is great in principle, since it helps lower inc ome individuals while encouraging them to get into the labour force. But I think there's a problem in the way it is set up. The way it works now is that you get a check when you go to file your taxes. On April 15, you and I may pay taxes. B ut lower income people in the US get a check from the government. We have done s ome pilot studies talking with people who get these checks, and the problem is t hat they do not really see how the amount they get from the government is relate d to how much they earn. So they understand that around February or March they g et a big check for about $3,000 to $5,000 or something like that from the govern ment. For them, it is a very large amount of money if they're making say $15,000 a year. The problem is that if they don't understand that working more affects the total amount of their income, then the whole point of the program is defeate d. The idea of the program is to encourage you to work more by making you realis e that your wage is higher. To understand how serious this problem is, we're doing an experiment with H&R Bl ock, the tax preparation company, with 40,000 low-income clients in Chicago, whe re we give them very simple information about how this program works. The tax pr eparers tell half the people (randomly selected) what I've just said to you: sup pose you earn $10/hour, you should really think of your wage as $14/hour because the government gives you $4 for every $10 you earn. Next year when they come ba ck to file their taxes, we're going to test if those 20,000 people to whom we ga ve this information increased their earnings relative to those who were not give n that information (the control group). We've already done the experiment in 200 7; in 2008 we will get the feedback. The question is whether 20,000 people in Ch icago are currently changing their work patterns this year based on the experime nt. What are your thoughts on welfare policies? In any country, welfare support is a very controversial area because I think the re are two strong competing arguments. Both in India and the US you see there's tremendous growth in incomes at the top end. Some people are becoming incredibly well off while others are not, and this suggests that you want to try to help t he lower income people share the fruits of growth. I just read that 80 percent o f people in India live on less than Rs 20 a day. At the same time, we have a gro wth rate of about 10 percent per year in India. The growth rate benefits a very small fraction of the population. You then think that we need to try to help the se lower income people in some ways through education subsidies, welfare payment s, earned income credit programs, and so on. This is the argument for welfare th at liberals would make. The danger in this argument is that you must take market forces into account. Ho w will you finance such a welfare program? If you finance it by taxing companies or wealthy people a lot, you essentially create a situation where I think it is like India in the 80s, there is not much growth because there is not that much incentive to start these new companies and make big investments because the gove rnment is taking a lot of the return. And on the other end, there's less incenti ve to work because the government is just supporting you. This is the argument a gainst welfare that conservatives would make. Both arguments are compelling and no doubt correct to some extent. So, you have to be very careful, that when you try to implement these big welfare policies, y ou do not reduce the level of economic growth such that everybody is not as well off. This is a very tough 'equity-efficiency' tradeoff. A lot of my research ha s focused on in what areas provide welfare support: where it is most valuable an d how can we minimize these efficiency costs. In general, I think that short-ter m income support programs can be very effective (eg, unemployment insurance, hea

lth insurance). I also think that there is probably tremendous value in improvin g literacy and primary school education for lower income individuals, so that yo u can help them earn a good living rather than support them with welfare payment s forever.