Monday, January 16, 2012

Externalities (or how to create a better tax structure)

Market Externalities are very likely the key to solving all our national problems. But, what are externalities? Externalities are costs or benefits to a person or to people who are not part of the market transaction. Pollution is a common example. In fact, in many ways, you can think of all of our problems as externalities. Problems that aren't externalities are often due to poor or non-existent incentives. Incentives that are often effected by externalities themselves.

People often say that unregulated markets are the most efficient system we can create for distributing goods and services. That is largely true, except in a few key areas. The first I'll be writing about here is externalities. I'll write about the inefficiencies of efficiency later.

Two farmers live next to a lake. One farmer loves to fish in his spare time, the other loves to sacrifice woodland creatures to Cthulhu. The second farmer realizes that if he plows his land right to the very edge of the lake he gets the best soil and the best yield. This also puts excess silt in the water killing the plants the fish feed on and the first farmer gets pretty upset by this. Not only that, the extra food the second farmer is growing has lowered the price for food and now the first farmer can't pay his mortgage. In desperation he also plants next to the lake. His farm is saved and he takes up mud wrestling as a hobby as there are no more fish.

Normally the solution is to pass a law that says you can't plow near the lake, but this has several problems. First, what if the first farmer figures out how to farm near the lake without any mud getting in the lake. The town is deprived of food that could be grown because the law did not anticipate this. Second, the second farmer discovers a part of his property that has all the same benefits of growing near the lake, and it is far enough away by law to plant. Unfortunately this land still washes mud into the lake even though it is farther away. Finally, the two farmers start working together to modify the law so that no new farms can be built unless they can prove that they will not put mud in the lake. Now the two farmers can raise the price of food knowing no third farmer will come in because they made it too tough to get past regulation.

Many economic libertarians believe there should be no public land. If the lake were owned, the owner would demand compensation for the mud in the lake and there would be no need for regulation. This is correct except it means that the local kids can't swim unless they pay this guy and since he is the only one with a lake, he can gouge people.

Can we get the same benefits from the libertarian idea and still keep the lake public?

Sure. We demand the same compensation as any private owner would want. How much do we want food versus how much do we want to swim? How much do we want fish? These all determine how much we charge the farmers.

Borrowing another bad idea often put into practice, why don't we impose a lake front tax? For however much lake front you have you pay X amount. That money will be used to filter the lake. This suffers from many of the same regulation problems. It doesn't encourage anything other than weaseling around the law.

So what is the solution that has near universal economist support? Tax the externality. Imagine if instead of the other solutions we charge the farmers based on the quantity of mud they individually put in the lake. The first farmer discovers how to avoid the tax by using new technologies to not get mud in the lake in the first place. The second farmer decides it's worth the extra cost to plow that area that puts mud in the lake. The first farmer realizes he could license his technology to the first farmer for a price just less than the externality tax. Clean lake, new technology, plenty of food.

The system uses the market forces in a positive way rather than a negative. The desire to save money encourages technology. The lack of regulation means the farmers can respond to market demands with well understood trade offs.

What can go wrong?

What if the tax isn't the right amount? This is easy. Just nudge the numbers around a bit to get to the desired outcome. If food is scarce and the people think the lake doesn't have to be that clean, lower the tax. If the lake is still too muddy, raise the tax. Determining a start point to the tax is not very difficult. It's simply a matter of calculating all the positive and negative externalities and adding that as a modifier into the market. What if one farmer tries to cheat the system? The other farmer has an economic incentive to catch him. If there is no other source of mud, it must be the two farmers. If one farm jiggers the numbers, the cost is borne by the other. The two farmers are in the best position to watch each other. What if they claim X amount comes from nature? This will be quickly absorbed in the pricing of the tax as will the lakes natural ability to absorb some silt. If the number is too high, it will be reflected in the outcome, the lake.

These externality taxes give us a simple way to determine what is more valuable to us. When food is scarce, we give up a cleaner lake. When food is plentiful we want a clean lake. The clean lake gives us better fish at a cheaper price. Our kids get healthier through exercise. We may feel this is worth the extra cost on food.

This is already pretty long so I'll write another post on the many ways both positive and negative externalities can be used to create desired outcomes. 

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