The Income Treadmill

---

The post below is a version of a blog post I wrote for Atlas Point on January 25th, 2024.

Introduction

In a recent Wall Street Journal article, Joe Pinsker examines the effect receiving an increase in income (e.g., via a raise) has on happiness. Behavioral economics provides significant insights into this subject, indicating that the impacts of a salary increase are intricate and multi-layered. The relationship between money and happiness is a broad topic, and one that has been explored across various fields including economics, psychology, and sociology.

Consumer Impacts

A change in a consumer's income can have far-reaching effects on not only their happiness, but other aspects of their life as well. While increases, decreases, and stagnation in an individual’s income has different effects, I am going to focus on the effects of an increase in income. While many people would assume that a raise or other form of income growth would have a strictly positive effect on an individual’s happiness, this is not the case. While a consumer's happiness may increase, due to something called hedonic adaptation—the finding that individuals quickly become accustomed to the good and bad things their lives and those things stop having as strong of an impact on their happiness over time—the effects are not long-lasting (usually two weeks or less).

From a non-psychological perspective, increased income can have the following financial impacts:

• Higher Savings: Increased income often allows for more funds to be put into various savings vehicles.

• Reduced Debt: Individuals may pay down any debt more quickly, which reduces the amount paid on interest, freeing up additional income.

• Investing Pursuits: Higher earnings could be allocated to stocks, bonds, real estate, or alternative investment options, offering the possibility of accruing further wealth.

• Lifestyle Changes: Increased income can result in lifestyle improvements, such as traveling, education, healthcare, housing, and general quality of life.

• Greater Consumption: Individuals may spend more on both utilitarian and luxury items, which often leads to a higher standard of living.

• Financial Security: Being able to allocate more income towards unforeseen expenses can have a positive psychological effect on individuals.

• Tax Changes: A higher income could push an individual or household into a higher tax bracket--increasing their tax liability.

• Social Dynamics: Having more income can affect social status and relationships (both positively and negatively).

• Giving More: More disposable income, means individuals might donate more to charities and causes they care about.

Behavioral Insights

It's important to recognize that the effect a raise has on a person's happiness hinges directly on how they respond to their changed financial situation. Some main findings that inform behavior include:

Hedonic Adaptation explains why changes in our lives quickly lose their novelty--the luster of something new quickly fading into the familiar. For example, think of acclimatizing to the temperature of a room--at first, the room may feel exceptionally hot or cold, however, over time, the warmth or chill of the room becomes less and less noticeable as our bodies adapt. With a raise, an individual may feel initial excitement and joy, but as the new income level becomes a part of everyday life, those initial feelings quickly dissipate.

Reference Point Effects (Loss Aversion, Status Quo) are psychological responses we have to movements away from our "reference point." These movements can either be gains or losses depending on the reference point and the new state. In the context of a raise, the reference point was the previous salary and the "gain" is the new salary (unless the new salary was expected, but that's a post for a different day). The effect that a reference point has on an individual's happiness occurs both when the income shift happens and after adaptation. An individual will feel happy as they gain income relative to where they were before; however, once they have fully adapted to this new income, it becomes the reference point. Because of this, any pursuant income decrease can make lifestyle changes incredibly difficult.

Social Comparisons are the unavoidable comparisons we make with others in order to evaluate our own success (e.g., some people compare their house to their neighbor's to determine whether they have a nice house).The boost in happiness one receives from a higher income can be muted by how one's earnings compare to those in their peer group or neighborhood. The most important factor in money-related happiness isn't just how much one earns, but how that income compares to others around them. High-income individuals often engage in upward social comparisons, meaning they compare themselves to those who are better off. As one's income grows, these upward comparisons persist—there's always someone who earns more—leading to a diminished sense of happiness.

Paradoxically, the things that truly make us more happy are often negatively correlated with higher incomes.

So what can individuals do to make the most of their new raise?

• Hedonic adaptation is unavoidable—the only way to counter it is through expectations—recognize that this increase in income will only feel "life-changing" temporarily and don't expect it to act as a panacea to existing issues in your life.

• The most effective way to mitigate reference point effects is to never let them happen. The easiest and most effective way to do this is to avoid integrating your new income into household cash flow (this is assuming the income becomes solely disposable). Use the money for savings or investments (and preferably via automatic deposits) instead. This will keep you at your current reference point in terms of lifestyle and income expectations, while building wealth at no psychological cost.

• The motivating nature of social comparisons could potentially overwhelm the advice to not integrate the new money into household cash flows. Individuals are almost always inclined to use new money to improve their lifestyle (i.e., keeping up with the Joneses). While social comparisons are hard to avoid--much of the value we place on things in our life is determined relatively--try to keep in mind that life stage, income levels, and personal values can all make such comparisons unhelpful and misleading. Focus instead on personal goals and progress rather than how others are doing and remember that outward success can be a facade.

Understanding what actually makes people happy (at least more happy than income levels) can also prove helpful in dealing with the psychological fall out of receiving an increase in income. Factors that have the largest positive effects on a person's happiness level include: reduced commute times (the time it takes to commute has the largest effect on an individual’s happiness), increased leisure time, employment that does not entail a lot of time pressure, having a position that offers excellent benefits or perks, improved sleep quality, and good health. Paradoxically, the things that truly make us more happy are often negatively correlated with higher incomes.