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When Pigous Don't Have Wings

My podcast with Greg Mankiw is now up at EconTalk. (This replaces the interview with John Bogle, the inventor of indexed mutual funds, which alas, has been postponed. Meanwhile, for a taste of the economics of indexed mutual funds, go here.)

Greg and I talk about Keynes, and macro and the multiplier and deficits and entitlement programs. We also spend a lot of time talking about the virtues and drawbacks of increased taxes on gasoline.

Greg calls those who support the higher taxes on gasoline, members of the Pigou Club, in honor of A.C. Pigou, the British economist who pioneered the uses of taxes and subsidies to correct externalities—what are sometimes called spillover effects. If I put garbage into the air or into a lake or stream, some or much of the cost is going to be external to me—it will be imposed on others. Therefore, goes the standard story, there will be  more pollution than would occur if the costs were  all imposed on me.  To  correct my incentives, Pigou argued, impose a tax on me equal to the extra costs I impose on others. 

Drivers impose externalities on others in the form of air pollution, traffic and possibly global warming. Because driving is too cheap, goes the argument we do too much of it. So to align the incentives correctly, says the Pigovian, raise the tax on gasoline. In his manifesto, Greg lists additional reasons beyond pollution and global warming in making the case.

I have no problem with the theory behind this general argument. Yet I still can’t join the Pigou Club. I make some of the counter-arguments in the podcast—they essentially have to do with how such a proposal is implemented when the political process gets a hold of it. Greg’s answer is that yes, there are going to be political complications, but if we let political complications stand in the way of good economic policy, we may as well fold up our tent and go home. There are always going to be political complications. So if economists want good policies, they should advocate good policies even if in practice, they may not always turn out ideally.

Who’s right? What should economists advocate in these situations? I’ve been thinking about this a lot ever since I interviewed Richard Thaler. Shouldn’t we support having government encourage (not force) people to make better decisions if without that encouragement people will make bad decisions? My answer is no. I don’t expect pigs to fly. Why should I expect government to be good at helping people make good decisions?

The standard argument against government intervention to correct market failures is that you have to look at government failure, too. It would be naive to argue that we shouldn’t worry about pollution because people will feel guilty polluting and that will discourage pollution. Similarly, it strikes me as naive to encourage government to solve the pollution problem via a gasoline tax if you know that the level of the tax will be set wrong and that the money will be badly spent. On the podcast, Greg counters this point by asking whether I’d favor a tax increase coupled with a tax cut or a tax increase coupled with eliminating CAFE standards, say. Probably, I answer, but that strategic advocacy seems very different to me than economists coming out for a gas tax on efficiency grounds.

We didn’t get to discuss this in the podcast, but I assume CAFE standards exist not because politicians are stupid but because politicians are smart. It strikes me as rather strange to advocate replacing CAFE standards with a gas tax. It’s certainly OK to explain why one tax is a more effective way of reducing gasoline consumption. But I wouldn’t hold my breath waiting for it to happen or spend a lot of effort trying to make it happen. Politicians prefer complex policies that redistribute income to their friends and encourage friends and enemies to lobby for changes in the law, relative to decentralized solutions where it’s hard to claim credit for the benefits.

That’s the Stigler in me. The Friedman in me says we should push for changes like that as well as anything that makes government smaller. But advocating a gas tax simply because driving produces externalities is a move in the wrong direction.

But listen to Greg on the podcast. He gets plenty of air time to make his case. Maybe he’ll convince you.

POSTSCRIPT: The theoretical counterpoint to Pigou is Coase, who we do discuss in passing on the podcast. Here’s my attempt to use Coase to explain why some externalities should be ignored.


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