Pigou and the Poor

Or, being able to buy a better life is the whole point of being rich!

After explaining the idea of negative versus positive externalities, economics textbooks offer a pair of elegant remedies inspired by economist Arthur Pigou.

The Pigovian remedy for negative externalities: set taxes equal in magnitude to the severity of the externality — and then leave the market alone. No regulation, no bans.

The Pigovian remedy for positive externalities: set subsidies equal in magnitude to the severity of the externality — and then leave the market alone. No regulation, no government ownership.

Economics textbooks often insinuate that actually-existing governments roughly follow this logic, but that’s preposterous. Almost no government raises a significant share of its revenue from taxes on negative externalities. And even when governments heavily tax negative externalities, they also impose piles of regulation. Similarly, governments strongly prefer to directly own industries with (alleged) positive externalities. Subsidies to industries with positive externalities are small by comparison.

Why don’t governments follow Pigovian logic? First and foremost, because demagoguery rules the world. The vast majority of voters are economically illiterate, and politicians pander to their misconceptions.

Still, thoughtful objections to Pigovian policies do exist. One of the best is distributional. Phrased in the form of a question: Aren’t Pigovian policies bad for the poor?

Well, aren’t they?

On reflection, the answer is normally No. Yes, Pigovian taxes on negative externalities deliberately try to raise prices. But standard command-and-control regulation indirectly has exactly the same effect. And since Pigovian taxation has better bang-per-buck than regulation, the indirect price effect of regulation is normally much higher than the direct price effect of taxation.

The same goes for positive externalities. Both subsidies and government supply try to reduce prices. But reducing prices efficiently via subsidies costs a lot less than reducing prices inefficiently via wasteful government ownership.

The most credible exception: Government often rations its services via queueing rather than price. Road congestion is the most obvious example. Since the poor value their time less than the rich, it is possible that the poor are, in such scenarios, net gainers.

Yet even this is far from clear, for two main reasons. First, all the time people waste in line could have been used to produce goods and services that the poor would have purchased. Second, the poor, like everyone else, are risk-averse — and queueing is unreliable. With gratis roads, you think, “Getting to work will take somewhere between 30 and 90 minutes.” With peakload pricing, you know, “I can get to work in 30 minutes if I pay the toll.”

That said, a much more fundamental response to the “Aren’t Pigovian policies bad for the poor?” challenge exists. A response that Social Desirability Bias urges us to suppress.

But I’m going to tell you anyway.

Yes, Pigovian policies allow the rich to buy their way out of many of the inconveniences that we now take for granted. In a Pigovian world, the rich won’t have to wait in traffic, deal with low-flow plumbing, or choose between free K-12 and full-price private school. But what’s wrong with that?! Being able to buy a better life is the whole point of being rich! Existing societies already allow the rich to have better houses, cars, and food. Why not also allow them to enjoy all the convenience that money can buy?

Key point: If you think that distribution is too unequal, the prudent solution isn’t to hobble vital industries to ensure that the rich suffer like the rest of us. The prudent solution is more redistribution. Are you worried that more redistribution will be bad for incentives? Then you should be relieved to know that Pigovian policies will be good for incentives. The wider the range of problems you can solve with money, the better it is to earn lots of money by producing lots of valuable stuff.

“Being able to buy a better life is the whole point of being rich!” Once you come to terms with this truism, another epiphany awaits. Namely: Giving the rich a whole new class of luxury goods to spend money on reduces their demand for everything else! Which in turn makes existing goods — especially luxury goods — more affordable for the rest of us. In a Pigovian world, the rich take a good chunk of the money they currently spend on fancy homes, foreign travel, five-star hotels, and performance automobiles, and use it to live care-free. Which means lower prices for fancy homes, foreign travel, five-star hotels, and performance automobiles for the rest of us.

Contrary to many, I have no trouble understanding how psychologically normal humans think and feel. If this essay were widely read, I realize that Pigovian policies would probably become less popular than ever. But it is humanity, not my arguments, that is flawed. Rationally speaking, Pigovian policies are probably far better for the poor than than the status quo. And if you tolerate inequality in housing, cars, and food, you should definitely tolerate inequality in convenience, too.

This book is good!