Why I’m skeptical about corrections for market failures

In almost every economics textbook you will find a discussion of market failure. The conversation will usually go something like this: Markets are great, but sometimes they fail. If transaction costs are low, no government action is necessary. But if transaction costs are high, the government can (and should) intervene to correct the failure. One of the most commonly used methods to correct market failures is British economist Arthur C. Pigou’s original: taxes.

A Pigouvian tax is a tax intended to solve a specific market failure: negative externalities. A negative externality is a situation in which costs are imposed on a third party outside the transaction. Because they are not part of the original transaction, the monetary price that occurs in the market does not fully take into account their costs. Thus, a tax can be imposed that increases the market price, reduces the quantity in the market, offsets the costs imposed, and eliminates the market failure. Negative external factors seem to be ubiquitous in society (pollution, bad odors, passive smoking, etc.). Moreover, transaction costs are high (imagine if a power plant had to negotiate with everyone affected by the smog!). Consequently, there are many economists who take the need for Pigouvian taxes as a given.

However, I am very much in the minority. While I understand the logic behind Pigouvian taxes, I reject them as a practical solution; I don’t think they are the first or even the twelfth best solution to market failure. Public Choice Economics gives us an important reason to be skeptical of government-imposed market failures, even so-called “market-based” interventions like Pigouvian taxes or cap-and-trade. The assumption behind Pigouvian taxes (or any government intervention in the economy) is that the government is a benevolent dictator; it tries to do the right thing and can do so unilaterally. But Public Choice teaches us that we must take the world into account as it really is as opposed to some idealized alternative state.

In the real world, government is neither benevolent nor a dictatorship. Government agents are not benevolent, but generally not malicious either. They, like all of us, are looking for their own interests. They want to keep their jobs, they want to do a good job, they want to go home to their families at the end of the day, etc. They have hopes, dreams and desires. And they act according to their incentives and their goals, which are likely different from most other people. What incentive is there then for them to allocate ‘the right’ tax to solve an externality, or even to gather all the necessary information to allocate it properly?

In the real world, government (at least in the United States) is not a dictatorship. It has many working parts. Many policy decisions are made in committees, or determined by vote in Congress. Policy makers and decision makers bring many, a lot of different problems. As a result, more often than not, policy deviates from a theoretical ideal and leans more toward politically correct behavior. (By that I mean: the policy is correct for some politics goal instead of a non-political goal.)

In a recent post, Pierre Lemieux highlights an example of such a case of politically correct policy: tariffs on Chinese-made electric vehicles (EVs). We are often told that global warming is a major problem that warrants significant government involvement. It is even the justification for many government subsidies for green energy (a reverse Pigouvian tax) and a carbon tax. From that perspective, tariffs on Chinese-made electric cars are meaningless. If there is a negative externality, and there is a product on the market that can reduce the externality, why would you effectively ban this? The answer: because those cars weren’t politically correct. They have solved the market failure, but not in the politically desirable way. Therefore, the government, wanting to protect its voter base and achieve its own goal of remaining elected, has chosen to take an action that reduces its externalities. worse instead of better. All in the name of stopping the appearance.

Why am I against a carbon tax? Because I see no reason why it won’t also be subjected to such political correctness. Even if it were possible to calculate the necessary tax accurately and free of charge, why would we believe that it would not be implemented and designed in a way that favors and politics goals rather than economic ones?