Consumer Law Myopia

The consumer credit market for low-income households in the United States is characterized by high interest rates, harsh default terms, and exotic fee schedules with low upfront fees and outsized deferred costs. Why do people accept credit on these terms? One possibility is that borrowers are rational but liquidity constrained. If this is the case, then these credit products satisfy consumer demand that, if unmet, would leave the individuals worse off. Regulation in this context should focus on ensuring that borrowers have full knowledge about the terms on which they borrow but avoid placing limits on the substantive terms of the credit products. 

An alternative explanation, which has wide currency among scholars and policymakers, is that people mistakenly and excessively discount the future costs of repaying their debts because they are impatient and impulsive. On this view, even individuals who understand the terms of their debts can be made worse off by borrowing and so there is a prima facie case for regulating the substantive terms of the debt contracts to eliminate those features that tempt people to borrow against their own interests. The economic models of 'present bias' that provide this second explanation have been a workhorse of consumer finance scholarship, and they draw from a deep well of evidence and theory in behavioural law and economics. 

In a forthcoming paper, I argue that legal scholarship in this area has tended to neglect a crucial question in assessing the welfare consequences of credit that appears designed to exploit present bias: what are the borrowed funds being used for? The same models of present bias that explain demand for high cost credit with deferred payment terms have different welfare implications depending on whether the debt is:

1. a secured loan use to acquire a durable good, such as a home or car, or 
2. revolving debt, such as a credit card, used to finance a vacation or some other form of current consumption.

The reason it matters is straightforward. The same person who suffers from present bias and is therefore tempted to incur large future costs to finance modest consumption benefits today is also disinclined to suffer a modest decline in current consumption to enjoy a significant amount of consumption in the future. Thus, individuals with present bias prefer to rent rather than purchase durable goods. Purchasing a durable good requires saving enough to either purchase the good outright or at least make a down payment, and saving is what people with present bias struggle to do. 

This means that scholars and policy analysts who study debt that appears designed to exploit present bias must make a sharp distinction between debt that can only be incurred to purchase a durable good (such as a home purchase mortgage) and debt that can be used to finance any sort of consumption at all (such as a credit card). In the case of a durable good, the tempting credit terms may entice the borrower to do something that she should, but wouldn’t otherwise, do.

More generally, credit products that backload costs and frontload benefits can be a helpful inducement to cause present-biased people to engage in costly activities that have frontloaded costs and backloaded benefits. I explore this effect with a study of tax refund anticipation loans (RAL). In the United States, a private industry of tax return preparers has historically sold financial products in connection with tax preparation services. The most popular of these, particularly among low income households, has been the RAL. Roughly speaking, a RAL allows the tax return preparer to advance to its clients the anticipated income tax refund that the client is owed, net of certain fees. When the United States Treasury disburses the individual’s tax refund, the proceeds are used to pay off the loan. 

RALs are short-term (only a couple of weeks), secured loans with very high interest rates. For present-biased individuals, however, they convert an unattractive bargain (incurring the time and expense of working with a tax return preparer now to get a large tax refund in the future) into a tempting one (receiving a large cash payment now in exchange for a larger tax refund in the future). In the absence of a RAL, a present-biased individual may not seek tax preparation assistance or even file a tax return at all. 

In 2011, supply-side disruptions originating from financial regulators and the Internal Revenue Service almost entirely eliminated the RAL market. I find that roughly 80% of the taxpayers who would have taken out a RAL (but were unable to) switched to an alternative credit product, while 10% of taxpayers decided to forgo paid preparation services altogether. Troublingly, 5% of previous RAL borrowers stopped claiming the earned income tax credit, a refundable tax credit that is the second largest federal transfer to low-income households in the United States. 

The data do not allow me to cleanly distinguish borrowers who are rational and liquidity constrained from those who are present-biased, but the effects of the disappearing RAL market are disappointing in either case. If individuals are perfectly rational, then regulating out of existence a financial product for which there is a lot of demand will only harm consumers. Moreover, even present-biased consumers can benefit from seemingly exploitative loans if they are bundled with a good or service that they should, but wouldn’t otherwise, buy. 

Andrew T Hayashi is Class of 1948 Professor of Scholarly Research in Law at the University of Virginia School of Law.