Myopic Consumer Law

Article — Volume 106, Issue 3

106 Va. L. Rev. 689
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*Class of 1948 Professor of Scholarly Research in Law, University of Virginia School of Law. Thanks to Jennifer Arlen, Oren Bar-Gill, Gustavo Bobonis, Tom Brennan, Ryan Bubb, Mihir Desai, Brian Galle, Yehonatan Givati, Jacob Goldin, Daniel Hemel, Louis Kaplow, Lewis Kornhauser, Kory Kroft, Day Manoli, Ruth Mason, Patricia McCoy, Alex Raskolnikov, Kyle Rozema, Emily Satterthwaite, David Schizer, Kathryn Spier, Rory Van Loo, David Walker, George Yin, workshop participants at the American Law and Economics Association Annual Meeting, the Columbia Law School-Hebrew University Tax Conference, the University of Toronto, Boston University, Cardozo Law School, New York University, and Harvard Law School. Thanks to the Brookings Institution and AggData LLC for providing data. I am especially indebted to Kent Olson of the UVA Law Library for exceptional research assistance.Show More

People make mistakes with debt, partly because the chance to buy now and pay later tempts them to do things that are not in their long-term interest. Lenders sell credit products that exploit this vulnerability. In this Article, I argue that critiques of these products that draw insights from behavioral law and economics have a blind spot: they ignore what the borrowed funds are used for. By evaluating financing transactions in isolation from the underlying purchase, the cost-benefit analysis of consumer financial regulation is truncated and misleading. I show that the same psychological bias that allows someone to be sold an exploitative loan also makes it possible that the exploitative loan benefits them by causing them to purchase a product or service that they should, but would not otherwise, buy. I demonstrate the importance of this effect in a study of tax refund anticipation loans. I find that regulation curtailing these loans increased the use of an alternative credit product and reduced the use of paid tax preparers and the take-up of the earned income tax credit.

Introduction

Behavioral law and economics has had significant influence on the regulation of consumer credit.1.See, e.g., Ryan Bubb & Richard H. Pildes, How Behavioral Economics Trims Its Sails and Why, 127 Harv. L. Rev. 1593, 1644–47 (2014).Show More This is both important and justified. It is important because consumer finance is central to the functioning of a modern economy; it is what President Obama called the “lifeblood” during the height of the financial crisis in 2009.2.Address Before a Joint Session of the Congress, 1 Pub. Papers 145, 147 (Feb. 24, 2009).Show More At the level of individual households, consumer credit is important because the timing of income and expenses are rarely contemporaneous. And yet, credit transactions are fraught. Credit both reflects and perpetuates wide differences in individuals’ economic opportunities and their vulnerability to financial adversity. Credit is more expensive for the poor, and this fact creates a patina of exploitation and abuse over debt transactions that has resulted in extensive state and federal regulation.

The influence of behavioral economics on consumer credit regulation is justified because two features of consumer credit raise doubts about consumers’ ability to make borrowing choices that are in their best interests. The first feature is complexity. Consumer debt often has a complex fee structure, opaque repayment terms, and default consequences that are hard to evaluate.3.For a discussion of the importance of complexity and faulty borrower comprehension in consumer credit markets, see Lauren E. Willis, Decisionmaking and the Limits of Disclosure: The Problem of Predatory Lending: Price, 65 Md. L. Rev. 707, 766–98 (2006) [hereinafter Willis, Decisionmaking and the Limits of Disclosure]. Unfortunately, interventions to increase consumer financial literacy do not appear to help remedy these problems. Lauren E. Willis, Against Financial-Literacy Education, 94 Iowa L. Rev. 197, 201 (2008); Lauren E. Willis, The Financial Education Fallacy, 101 Am. Econ.Rev. 429, 429 (2011). Because financial education and disclosure have proven to be largely ineffective, Professor Willis has provocatively argued for an alternative known as “performance-based consumer law.” Lauren E. Willis, Performance-Based Consumer Law, 82 U. Chi. L. Rev. 1309, 1311 (2015).Show More The second feature is the tradeoff between current and future purchasing power that is at the heart of every credit transaction. It is the essence of debt that the borrower exchanges her promise to pay amounts in the future for the ability to consume more now. This intertemporal tradeoff is one that individuals often struggle to make properly, and the challenge is especially great for individuals who focus excessively on the short term and who are therefore inclined to borrow impulsively and on terms that they subsequently regret.4.See Ian M. McDonald, The Global Financial Crisis and Behavioural Economics, 28 Econ. Papers 249, 251 (2009).Show More Both complexity and intertemporal choice are areas where behavioral law and economics scholarship is able to traffic in deep intuitions and draw on strong empirical evidence to make recommendations about how to regulate imperfectly rational consumers.5.I am unaware of any data about the intuitive appeal of complexity and impatience as explanations for why people struggle to evaluate credit contracts. Nevertheless, I trust that most readers, particularly those with home mortgages, will be inclined to agree that understanding all the terms of a secured loan, even when one is trained in law or economics, demands a great deal of time and effort. It is unsurprising then that some do not even make the effort. Judge Posner famously declined to read the “boilerplate” on his own home mortgage. David Lat, Do Lawyers Actually Read Boilerplate Contracts?, Above the Law (June 22, 2010, 2:42 PM), http://abovethelaw.com/2010/06/do-lawyers-actaully-read-boilerplate-contracts-judge-richard-posner-doesnt-do-you/ [https://perma.cc/R574-VCQS]. I also expect that most of us identify with the present-biased individual, who procrastinates when it comes to unpleasant tasks and acts impulsively when it comes to food or leisure. For a review of the literature, see Lee Anne Fennell, Willpower and Legal Policy, 5 Ann. Rev. L. & Soc. Sci. 91 (2009).Show More

In this Article, I focus on arguments about consumer finance regulation that draw on research about “present bias,” which is a sort of myopia that causes people to focus on the present and neglect the future. I argue that consumer law scholarship that draws on these insights has itself been myopic. People borrow money in order to buy things, and scholarship has generally neglected to consider what borrowed funds are used for.6.Some researchers do think it is broadly relevant what consumers do with the loan proceeds, but none evaluate the bundled loan and purchase together from the perspective of a biased consumer. See, e.g., Shmuel I. Beecher, Yuval Feldman & Orly Lobel, Poor Consumer(s) Law: The Case of High-Cost Credit and Payday Loans, in Legal Applications of Marketing Theory (Jacob Gersen & Joel Steckel eds.) (forthcoming 2020) (manuscript at 10), http://ssrn.com/abstract = 3235810 [https://perma.cc/2ZRB-QQ44].Show More I show that focusing on the terms of a loan, isolated from the good or service that is purchased with the proceeds, leads to misleading conclusions about the benefits to the borrower. Integrating the costs and benefits of the underlying purchase with the terms of the credit transaction can upend standard conclusions about the effects of present bias and relocate efforts to improve consumer welfare from the regulation of financial products to the circumstances that create demand for high-cost credit in the first place. I demonstrate the significance of this theoretical claim by reporting results from a study of tax refund anticipation loans (RALs), which shows how RALs increase the use of paid tax preparers and the take-up of the earned income tax credit (EITC) by low-income households. Because of the size of the EITC, these loans may make present-biased taxpayers better off, even if the loans are designed to exploit their bias.

When considering the benefits of credit transactions for present-biased consumers, why do the motivating purchases matter? The answer is that many goods and services are characterized by significant upfront costs but benefits that are only realized in the future. As I show in Part I, present-biased consumers tend to undervalue products with this temporal pattern of costs and benefits.7.See discussion infra Section I.A.Show More Durable goods, such as homes, cars, and appliances, are like this. Purchasing durable goods involves a significant cash outlay at the time of purchase in exchange for a stream of consumption benefits that are realized over time. In fact, all sorts of choices present this same temporal pattern of immediate costs and future benefits. For example, the benefits of education are mostly realized long after the classroom experience. Applying for social welfare benefits can require an upfront investment of time and effort in exchange for benefits that are received in the future. The EITC, which is the largest federal cash transfer to low-income households,8.Chris Edwards & Veronique de Rugy, Earned Income Tax Credit: Small Benefits, Large Costs, Cato Inst. (Oct. 14, 2015), https://www.cato.org/publications/tax-budget-bulletin/earned-income-tax-credit-small-benefits-large-costs [https://perma.cc/5L9L-RHX9].Show More is only available to individuals who file a tax return and complete the burdensome earned income credit (EIC) schedule.9.On the difficulties of filing for the EITC, see Michelle Lyon Drumbl, Beyond Polemics: Poverty, Taxes, and Noncompliance, 14 eJournal Tax Res. 253, 275–77 (2016); Francine J. Lipman, The Working Poor Are Paying for Government Benefits: Fixing the Hole in the Anti-Poverty Purse, 2003 Wis. L. Rev. 461, 464; George K. Yin et al., Improving the Delivery of Benefits to the Working Poor: Proposals to Reform the Earned Income Tax Credit Program, 11 Am. J. Tax Pol’y 225, 254–56 (1994). In her latest annual report to Congress, however, the National Taxpayer Advocate noted that the IRS has been working to improve EITC outreach and education. Internal Revenue Serv., Nat’l Taxpayer Advoc.,Ann. Rep. to Congress 144 (2017).Show More The key point is that when the deferred costs and immediate benefits of certain exploitative credit products are added to the immediate costs and deferred benefits of durable goods and services, the bundled transaction may be one that is appealing to a present-biased individual and makes them better off. The exploitative loan tempts the present-biased individual to do something that is in her interest but that she would not otherwise do.10 10.I say that a loan is exploitative if only biased borrowers want to borrow on its terms. This definition does not imply anything about the profitability of these loans to the lender or about the division of the gains from trade. For a philosophical treatment of exploitation, see Alan Wertheimer, Exploitation 7–8(1996).Show More

The results from this analysis sound a note of caution about decontextualizing the choices that consumers make. At the most general level, this Article shows that if consumer law is to help imperfectly rational consumers, it is not enough to show that certain goods or services would only be purchased by consumers acting on a bias that operates against their own interests. It must also consider what other choices these consumers are likely to make that depend on that product and how the exploitative product fits into the overall way that they have arranged their lives. The personal affairs of present-biased individuals are likely to be characterized by a variety of biased decisions that may be interconnected in important ways. Although the entire constellation of choices made by present-biased individuals will leave them worse off than if they made the same choices rationally, this does not imply that compelling them to make any one of these choices rationally will leave them better off.11 11.Law and economics scholars will recognize this as an application of the general theory of the second best to intra-personal choice. R.G. Lipsey & R.K. Lancaster, TheGeneral Theory of Second Best, 24 Rev. Econ. Stud. 11, 11–12 (1956).Show More

The second contribution of this Article is to consumer finance regulation specifically. Regulating the substantive terms of consumer credit requires distinguishing between different kinds of loan products and the uses to which the loan proceeds are put. Specifically, secured debt that must be used to purchase goods and services with deferred benefits has different effects on present-biased consumers than general unsecured debt that can be used to change the timing of consumption generally.12 12.Seediscussion infra Section I.A.Show More When we integrate the loan’s terms with the pattern of costs and benefits from the purchase that necessitated the loan, we see that the bundled transaction may in fact be beneficial for present-biased consumers.13 13.Seediscussion infra Section I.A.Show More If the bundled transaction is beneficial, then prohibiting credit terms that are designed to tempt present-biased individuals might hurt those that the ban is meant to help.

Third, and at the level of most direct application, the results of my empirical study have very specific implications for the regulation of RALs and refund anticipation checks (RACs). The results sound a warning to regulators about the effects of eliminating these products. RALs disappeared almost entirely following a regulatory change in 2011,14 14.See discussion infra Section II.D.Show More a change that was celebrated by consumer advocates.15 15.Chi Chi Wu & Jean Ann Fox, Nat’l Consumer Law Ctr. & Consumer Fed’n of Am., The Party’s Over for Quickie Tax Loans: But Traps Remain for Unwary Taxpayers 2 (2012), https://www.nclc.org/images/pdf/pr-reports/report-ral-2012.pdf [https://perma.cc/J9QX-QM­XK] (“While an occasional fringe lender may make a tax-time loan, the sale of RALs as a widespread industry-wide practice is over. RALs will no longer drain the tax refunds of millions of mostly low-income taxpayers.”).Show More The near elimination of RALs reduced the use of paid tax preparers, lowered take-up of the EITC, and increased demand for RACs.16 16.See discussion infra Part II.Show More RACs are popular, and RALs have begun to make a comeback, but both credit products are the focus of opposition from advocates and concern by regulators.17 17.Tax RALs are resurgent, albeit in smaller amounts than before. For a sense of the magnitude of this resurgence, there were 35,000 refund loans made in 2014 and approximately one million loans made in 2016. Kevin Wack, Tax Refund Loans Get a Second Life, Am. Banker (June 15, 2016, 2:49 PM), https://www.americanbanker.com/news/tax-refund-loans-get-a-second-life [https://perma.cc/ZG58-WG4M].Show More Thus, understanding the role they play in affecting tax compliance and the take-up of valuable social benefits is important and timely.

To be clear, present bias is not the only reason to be suspicious of credit transactions, and the purpose of my analysis is not to provide an all-things-considered appraisal of high-cost credit products. Complexity, unrealistic optimism about repayment prospects, and other psychological biases may cause people to choose financial products that are not in their best interests.18 18.Overly optimistic borrowers may borrow too much or too little. See Richard M. Hynes, Overoptimism and Overborrowing, 2004 BYU L. Rev. 127, 131.Show More I agree with scholars who emphasize the problem of complexity and the potential role for regulation in this area.19 19.See, e.g., Saurabh Bhargava & George Loewenstein, Behavioral Economics and Public Policy 102: Beyond Nudging, 105 Am. Econ. Rev. 396, 396 (2015) (arguing that behavioral economics should leverage gaps in the traditional economic approach that assume fully rational and informed individuals to deliver policy solutions).Show More But when regulation is motivated by concerns about borrowers’ psychological biases, it must consider not just how those biases generate demand for the product being regulated but also how that product is likely to fit into the life of someone who exhibits that bias more generally.

Part I explains the present bias framework for thinking about credit transactions and describes how present bias has been used to explain demand for three economically important, high-cost credit products. I show how integrating the underlying purchase transaction into the analysis of these credit products can change our conclusions about whether these products are beneficial. In Parts II–V, I report and discuss the results of an original study of the effects of regulating RALs. The results illustrate the theoretical effects I describe in Part I, provide evidence that is relevant for regulating this financial product, and raise hard questions about the intermediating role of the private sector between individuals and the U.S. Treasury. In Part VI, I describe a framework for thinking about the regulation of consumer credit products, paying special attention to RALs.

  1. * Class of 1948 Professor of Scholarly Research in Law, University of Virginia School of Law. Thanks to Jennifer Arlen, Oren Bar-Gill, Gustavo Bobonis, Tom Brennan, Ryan Bubb, Mihir Desai, Brian Galle, Yehonatan Givati, Jacob Goldin, Daniel Hemel, Louis Kaplow, Lewis Kornhauser, Kory Kroft, Day Manoli, Ruth Mason, Patricia McCoy, Alex Raskolnikov, Kyle Rozema, Emily Satterthwaite, David Schizer, Kathryn Spier, Rory Van Loo, David Walker, George Yin, workshop participants at the American Law and Economics Association Annual Meeting, the Columbia Law School-Hebrew University Tax Conference, the University of Toronto, Boston University, Cardozo Law School, New York University, and Harvard Law School. Thanks to the Brookings Institution and AggData LLC for providing data. I am especially indebted to Kent Olson of the UVA Law Library for exceptional research assistance.
  2. See, e.g., Ryan Bubb & Richard H. Pildes, How Behavioral Economics Trims Its Sails and Why, 127 Harv. L. Rev. 1593, 1644–47 (2014).
  3. Address Before a Joint Session of the Congress, 1 Pub. Papers 145, 147 (Feb. 24, 2009).
  4. For a discussion of the importance of complexity and faulty borrower comprehension in consumer credit markets, see Lauren E. Willis, Decisionmaking and the Limits of Disclosure: The Problem of Predatory Lending: Price, 65 Md. L. Rev. 707, 766–98 (2006) [hereinafter Willis, Decisionmaking and the Limits of Disclosure]. Unfortunately, interventions to increase consumer financial literacy do not appear to help remedy these problems. Lauren E. Willis, Against Financial-Literacy Education, 94 Iowa L. Rev. 197, 201 (2008); Lauren E. Willis, The Financial Education Fallacy, 101 Am. Econ.

    Rev. 429, 429 (2011). Because financial education and disclosure have proven to be largely ineffective, Professor Willis has provocatively argued for an alternative known as “performance-based consumer law.” Lauren E. Willis, Performance-Based Consumer Law, 82 U. Chi. L. Rev. 1309, 1311 (2015).

  5. See Ian M. McDonald, The Global Financial Crisis and Behavioural Economics, 28 Econ. Papers 249, 251 (2009).
  6. I am unaware of any data about the intuitive appeal of complexity and impatience as explanations for why people struggle to evaluate credit contracts. Nevertheless, I trust that most readers, particularly those with home mortgages, will be inclined to agree that understanding all the terms of a secured loan, even when one is trained in law or economics, demands a great deal of time and effort. It is unsurprising then that some do not even make the effort. Judge Posner famously declined to read the “boilerplate” on his own home mortgage. David Lat, Do Lawyers Actually Read Boilerplate Contracts?, Above the Law (June 22, 2010, 2:42 PM), http://abovethelaw.com/2010/06/do-lawyers-actaully-read-boilerplate-contracts-judge-richard-posner-doesnt-do-you/ [https://perma.cc/R574-VCQS]. I also expect that most of us identify with the present-biased individual, who procrastinates when it comes to unpleasant tasks and acts impulsively when it comes to food or leisure. For a review of the literature, see Lee Anne Fennell, Willpower and Legal Policy, 5 Ann. Rev. L. & Soc. Sci. 91 (2009).
  7. Some researchers do think it is broadly relevant what consumers do with the loan proceeds, but none evaluate the bundled loan and purchase together from the perspective of a biased consumer. See, e.g., Shmuel I. Beecher, Yuval Feldman & Orly Lobel, Poor Consumer(s) Law: The Case of High-Cost Credit and Payday Loans, in Legal Applications of Marketing Theory (Jacob Gersen & Joel Steckel eds.) (forthcoming 2020) (manuscript at 10), http://ssrn.com/abstract = 3235810 [https://perma.cc/2ZRB-QQ44].
  8. See discussion infra Section I.A.
  9. Chris Edwards & Veronique de Rugy, Earned Income Tax Credit: Small Benefits, Large Costs, Cato Inst. (Oct. 14, 2015), https://www.cato.org/publications/tax-budget-bulletin/earned-income-tax-credit-small-benefits-large-costs [https://perma.cc/5L9L-RHX9].
  10. On the difficulties of filing for the EITC, see Michelle Lyon Drumbl, Beyond Polemics: Poverty, Taxes, and Noncompliance, 14 eJournal Tax Res. 253, 275–77 (2016); Francine J. Lipman, The Working Poor Are Paying for Government Benefits: Fixing the Hole in the Anti-Poverty Purse, 2003 Wis. L. Rev. 461, 464; George K. Yin et al., Improving the Delivery of Benefits to the Working Poor: Proposals to Reform the Earned Income Tax Credit Program, 11 Am. J. Tax Pol’y 225, 254–56 (1994). In her latest annual report to Congress, however, the National Taxpayer Advocate noted that the IRS has been working to improve EITC outreach and education. Internal Revenue Serv., Nat’l Taxpayer Advoc.,

    Ann. Rep. to Congress 144 (2017).

  11. I say that a loan is exploitative if only biased borrowers want to borrow on its terms. This definition does not imply anything about the profitability of these loans to the lender or about the division of the gains from trade. For a philosophical treatment of exploitation, see Alan Wertheimer, Exploitation 7–8

    (1996).

  12. Law and economics scholars will recognize this as an application of the general theory of the second best to intra-personal choice. R.G. Lipsey & R.K. Lancaster, The General Theory of Second Best, 24 Rev. Econ. Stud. 11, 11–12 (1956).
  13. See discussion infra Section I.A.
  14. See discussion infra Section I.A.
  15. See discussion infra Section II.D.
  16. Chi Chi Wu & Jean Ann Fox, Nat’l Consumer Law Ctr. & Consumer Fed’n of Am., The Party’s Over for Quickie Tax Loans: But Traps Remain for Unwary Taxpayers 2 (2012), https://www.nclc.org/images/pdf/pr-reports/report-ral-2012.pdf [https://perma.cc/J9QX-QM­XK] (“While an occasional fringe lender may make a tax-time loan, the sale of RALs as a widespread industry-wide practice is over. RALs will no longer drain the tax refunds of millions of mostly low-income taxpayers.”).
  17. See discussion infra Part II.
  18. Tax RALs are resurgent, albeit in smaller amounts than before. For a sense of the magnitude of this resurgence, there were 35,000 refund loans made in 2014 and approximately one million loans made in 2016. Kevin Wack, Tax Refund Loans Get a Second Life, Am. Banker (June 15, 2016, 2:49 PM), https://www.americanbanker.com/news/tax-refund-loans-get-a-second-life [https://perma.cc/ZG58-WG4M].
  19. Overly optimistic borrowers may borrow too much or too little. See Richard M. Hynes, Overoptimism and Overborrowing, 2004 BYU L. Rev. 127, 131.
  20. See, e.g., Saurabh Bhargava & George Loewenstein, Behavioral Economics and Public Policy 102: Beyond Nudging, 105 Am. Econ. Rev. 396, 396 (2015) (arguing that behavioral economics should leverage gaps in the traditional economic approach that assume fully rational and informed individuals to deliver policy solutions).

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