The Pigou Club is out in full force this week in the form of Robert Frank’s Economic View column in the New York Times. He writes:
The production and consumption of many other goods, however, generate costs or benefits that fall on people besides buyers and sellers. Producing an extra gallon of gasoline, for example, generates not just additional costs to producers, but also pollution costs that fall on others. As before, market forces cause production to expand until the seller’s direct cost for the last unit sold is exactly the value of that unit to the buyer. But because each gallon of gasoline also generates external pollution costs, the total cost of that last gallon produced is higher than its value to consumers.
The upshot is that gasoline consumption is inefficiently high. Suppose that pollution costs are $2 for the last gallon consumed, but that its $4 price at the pump is just enough to cover its direct production costs. Reducing production and consumption by a gallon would then cause consumers to lose fuel that they value at $4, which would be exactly offset by the $4 in reduced production costs. The $2 in reduced pollution costs would thus be a net gain for society.
The “efficiency” of the gas tax, which seems to be the highlight of Frank’s piece is a suspect concept. The idea of an efficient tax to correct for a market failure such as an externality is based on Pigouvian welfare economics, which sees the tax as Pareto-improving. Yet, even members of the Pigou Club do not argue on behalf of Pareto efficiency (whether they are aware of it or not), but rather the Hicks-Kaldor criteria under which those who benefit gain enough to fully compensate those who lose, even if the compensation never takes place.
The problem inherent in any such analysis is the view of societal benefit and societal loss that is assumed to be easily calculated and dealt with through Pigouvian taxation. The ability to identify the social cost of a particular action is extremely difficult as each individual has his or her own subjective valuation. The problem is communicating each of these preferences in aggregate form to some central authority. This is a distinct problem in terms of both Hayekian knowledge and a neoclassical framework (Arrow’s Impossibility Theorem). In the absence of this ability, setting the tax rate is extremely difficult.
What’s more, the idea of externalities as a market failure misunderstands the role of the market and what is meant by efficiency. Markets are not efficient in the sense that they produce the optimal outcome of some economist, environmentalist, or other casual observer who wishes for a certain outcome. Markets are efficient because they serve to allocate resources to those who value them the most.
I would welcome a debate about what we should be taxing. I do believe that it would make sense to tax the things that we want less of. However, the Pigou Club is making the argument on the grounds of efficiency, which misunderstands both the term and the process through which the tax rate would be determined.