A Little Pigou Is A Dangerous Thing, Part 2

by Mario Rizzo 

Recently, some economists have proposed a new application of the Pigovian tax idea. This is to correct the newly-discovered problem of internalities. An internality is a side-effect on the future selves of a given individual. So, for example, if an individual eats too much now his future self, perhaps a decade or two hence, will experience costs (damages) – not certainly, but with some probability. Internalities are generated by lack of willpower, myopia or other decisionmaking deficiencies on the part of present agents. 

Now let us consider some of the problems in estimating the correct internality tax.  

First, we need to know the probability of harm. This is inextricably related to the course of medical technology in the future. How easily (cheaply) certain health problems will be cured or alleviated decades from now is obviously very hard to predict.  

Second, we need to know how far the individual’s present behavior is from the optimum. The answer is not obvious. People do care about their future selves to one degree or another. They do have self-regulatory or self-control capacities.  In the limit where people care about their future selves as much as the current selves, they will already be at the optimum, with no need of a Pigovian tax all at. In fact, a tax here will cause people to overshoot the optimum.  

In the non-limiting and probable case that people care but imperfectly about their future selves, simply taxing to the extent of the observed internality will lead to excessive restriction of their (eating) activity. The Pigovian needs to know the optimum amount of the activity before he can impose the appropriate tax — a tall order. (The tax must equal the difference between the social cost at the optimum and the appropriately adjusted full costs borne by the current self who cares about his future selves.) 

Third, it is unclear what caring sufficiently about one’s future selves would be. In the interpersonal case, the Golden Rule may be appropriate: Care about others to the same degree as you care about yourself.  

In the intertemporal context, however, we are quite accustomed to discounting future benefits and costs. So what is the “correct” discount rate? Without getting into details here, there is no unique normative rate.  

In view of these problems of carrying through the Pigovian program in a serious way, the consequence of attempting to correct the “internality problem” through taxation will be the capture of the policy by those who have another agenda. The most obvious one is the old paternalist agenda: Do this because I think this is best for you, not because you, at some deep level of preference, think this is best. And, depending on the specific issue, other partial-interest groups will seek to control the policy.  

It seems to me that Pigovian taxation is one of those ideas that looks far better in textbooks than it does in the real world. This is the problem with teaching it to undergraduates.  In a textbook all of the necessary information is right there in front of you. Students then come away from their textbook learning with a fantasy of what is feasible in terms of economic policy. Unfortunately, it is a fantasy that also afflicts even those who really should know better. What is their excuse?  

A little learning…   

Further reading: John Nye: “The Pigou Problem.”  

Glen Whitman:  “Against the New Paternalism: Internalities and the Economics of Self-Control”  

Mario Rizzo and Glen Whitman: “Knowledge Problem of New Paternalism.”

UPDATE: Greg Mankiw posts a statement by a fellow Pigou Club member on the carbon tax. Take a look at Nye’s criticisms of Pigovian taxes and then see how well they are answered in the post on Mankiw’s blog.

8 thoughts on “A Little Pigou Is A Dangerous Thing, Part 2

  1. It has been a couple of years since I read Rothbard’s critique of the concept of indifference and found it somewhat overstated. I’m not normally much patient when I can’t answer the question “Why should I care?”

    After some reflections, however, I extracted what I consider the fundamental kernel of truth of Rothbard’s arguments: because indifference can’t be observed, it can’t be the basis for any “welfarist” economic policy, as while economic theory can do without tracing real indifference curves, an economic policy that is not to be completely arbitrary need a criterion of choice, which however can’t be found outside preferences as revealed through individual actions.

    The idea of indifference makes theoretically sense, but, pragmatically, every policy justified in terms of indifference must face the knowledge problem of not knowing the real preferences of the coerced individual.

    So, it is “hypocrite”, or, more understatedly, theoretically impermissible, to justify paternalism in terms of the preferences of its subjects: paternalism is always about forcing the preferences of the “pater” (or his arbitrary ideas about other people’s preferences) above those of the subject.

    The same seems to be true for these new forms of welfarism: without a procedure to reveal my “real” preferences (whatever it means), why should they be better than me, even though insufficiently willpowered, in doing something for which there is no convincing pratical solution?

    Another instance of what Coase called “blackboard economics” and Hayek “pretence of knowledge”… it appears that the epistemological bridge between theory and history is not recognized as such by many modern economists, and the results are these…

    Makes sense?

  2. The essence of Glen Whitman’s and my criticism of new paternalism in our forthcoming Brigham Young University Law Review article is this very knowledge problem you mention. The paper is linked above.

    However, Rothbard’s own welfare economics is a nonsensical tautology. He is defining any deliberate act as welfare enhancing. This doesn’t add anything to the idea that non-invasive voluntary action should be allowed. (BTW, I’m okay with that.) Nothing an individual could ever do deliberately would invalidate Rothbard’s welfare conclusion.Of course, he’d have you believe that this is some brilliant exception-less law. Not even agents believe that their own actions *always* increase their welfare. How else does one explain self-constraining behavior?

  3. I agree with this assessment of Rothbard’s welfare economics.

    I downloaded the paper and read the introduction, so far I think it’s ok and I totally agree. Thanks.

  4. Mario, could you elaborate a bit on your critique of Rothbard? You seem to me to be confusing some ontological sense of “welfare” with Rothbard’s more restrictive, praxeological notion. His claim that voluntary action is necessarily welfare-enhancing, ex ante, is simply another way of stating the proposition that the only preferences that matter for economic analysis are those that can be demonstrated in action. It has nothing to do with what agents *believe* about their own well-being, even less so with what we, as responsible adults, think of our neighbors’ choices and what they should be doing instead to achieve true happiness.

    BTW I don’t see how Rothbard’s approach is inconsistent with self-restraint. Certainly Schelling’s smoker who gives his cigarettes away is demonstrating a preference for such a constraint.

  5. I have struggled with this issue in my critique of behavioral economics and its criticism of standard welfare theory. The idea that at the very moment of action a person thinks he is benefiting himself in some way is true. And necessarily so. It is embedded in the very concept of action as Mises and Rothbard define it. Action is, by definition, the pursuit of what the agent prefers. But so what?
    Most people do not find that interesting. Why? Because momentary conceptions of benefit that may be later regretted do not, again for most people, make a powerful case for the “welfare benefits” of the market. So I find it useful to argue about learning, knowledge problems of the paternalist, etc. I bet my criticisms will have more effect than Rothbard’s.

  6. I greatly admire your critique of paternalism and hope it will have a big impact. I’m just saying that you’re misstating what Rothbard was trying to do. His demonstrated-preference approach to welfare analysis was not intended to “make a powerful case for the ‘welfare benefits’ of the market,” but simply to define the concept of welfare in a praxeologically meaningful way. He thought the general case for the market required ethical arguments, not just economic ones.

    Incidentally, I’m sure you know Gary Lawson’s 1992 piece, “Efficiency and Individualism,” which critiques a number of welfare approaches, including Rothbard’s. Murray told me he really liked that piece, thinking it nicely showed the limits of welfare economics more generally. Maybe economic analysis per se simply can’t say as much about welfare, in a way that appeals to most people, as we think it does.

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