My Problem with Pigou

© 2009 Joshua Stark

Nowdays, there is a movement afoot in economics right at the junction of economics, ethics, and the environment, based on the works of an obscure (to normal humans) economist.
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Arthur Cecil Pigou was a prominent economist of the early to mid-20th century, and his work has influenced a number of studies in economics, but the one that is coming to prominence in recent years is the push to "internalize externalities." Pigou proposed a tax on transactions with negative externalities, because they are cases of market inefficiency.

There are two ethical claims here: 1) Economists believe it is unfair for someone to be hurt by other people's transactions; and 2) economists believe that market inefficiencies are wrong behaviors. The second one is a little more debatable, but I believe that the first one is just about as universally held a belief as one will find on Earth.

What a Pigouvian tax is, then, is a tax on a transaction intended to help mitigate the effects of its negative externality. Here is an example:

Say you buy 50 gallons of diesel fuel for your truck. As you drive off, the exhaust from your truck aggravates a kid's asthma. That child is rushed to the hospital, and her life is saved.

Who paid for the hospital trip? Who should pay? The visceral reaction is to feel at least partially responsible for the problem. Of course, in the real world, we pretend that we can't really determine these causes and effects so cleanly, but it's really because we can't determine whose specific particle aggravated the asthma, not because we don't think the situation is wrong.

But we do know that diesel exhaust is bad. We, as a society, are picking up the tabs for diesel's effects (called social costs), especially when the child doesn't have health care. This is a negative externality resulting from the purchase of diesel; the deal was between you and Chevron, the kid had nothing to do with it, and yet, she goes to the hospital, and I have to help pay.

Economists see this as a market failure, and some have proposed that, to help alleviate that failure, we should tax the item. The tax will raise the price of the item, lowering its quantity demanded in the market. In the case of diesel, this means that less diesel exhaust will occur in the air, because people will buy less of it.

The Pigouvian tax is widely accepted in economic circles, it crosses ideological lines, and in fact, there exists a Pigou Club of economists and wonks who believe in its use.

So, what's my beef with it? Well, first, it's a regressive tax, like all sales taxes. A regressive tax is one that has a larger percentage impact on poorer people than richer people. In our example, a person making $10k/year would pay a higher percentage of her income to the diesel tax than a person making $100k/year. My ethical claim is that poorer people should not pay a higher percentage of tax than richer people. Worse yet, some are calling for Pigouvian taxes to take the place of income taxes, which are progressive taxes (that is, the rich pay a higher percentage than the poor). This is an untenable long-term revenue situation for government, and it's bad macroeconomic thinking, too, for a couple of reasons.

Last, there is no guarantee that the revenues will not ruin the impact of the tax on externalities. Consider this: The construction industry lobbies for an exemption to the tax, on the grounds that it impacts jobs; the government exempts the insurance industry by providing an income tax exemption or a subsidy; the company bosses tell their folks to fill up, because they can just write it off at the end of the year. A person can conceive of a situation where more diesel gets consumed than previously (look at ag. subsidies now, if you don't believe that's a possibility).

But, in order for people to have the incentives to make honest economic choices, we need some way to internalize these externalities. We are all paying the social costs, so not having a price tag on their impacts at the diesel pump gives us a false price for diesel when we buy it. Since we can't ask for people's income statements at the pump, what do we do?

The solution I agree with is to help ensure that the tax (placement and revenue) helps alleviate the externality. This can be accomplished through a rebate of the Pigou tax to everybody, a combination of flat-out equal checks to every citizen of the country of a portion of the tax, and improving health care and non-citizen third-party impacts like air and water pollution problems in the wild lands. The rebate takes care of the regressive tax problem, and the projects to improve wild lands will help alleviate externalities there, too.

So, don't go asking me to join the Pigou Club until it comes with these fixes. Though, I doubt seriously that I'd be asked, anyway.