Why We Should Ignore Fiscal Externalities

Government shouldn't seek to maximize your net tax contributions

Lifestyle controls by governments—especially taxes and regulations—often get justified on the basis that one person’s behavior may harm third-parties outside of the transaction (so-called negative externalities).

Take alcohol. Across the population as a whole, drinking probably brings net costs to the broader community beyond those consuming the product, including the effects of drunk-driving/DUIs and alcohol-related crime and disorder.

Since these costs don’t fully factor into peoples’ private drinking decisions, such “external costs” mean the “social costs” of alcohol consumption exceed the “private costs” to the individual consumer. Given the costs and difficulties of private actors finding solutions to this problem, mainstream economists would typically say that without some corrective intervention from government to account for these negatives externalities (probably an alcohol duty or tax), alcohol would be over-consumed in a free-market.

Let’s put aside the robust critiques of this framework. For better or worse, it’s conventional economic wisdom. Yet in the last decade or so, many campaigners and government agencies have pushed the boundary on what should be considered a negative externality. A 2015 report by the Centers for Disease Control and Prevention estimated, for example, that alcohol consumption costs the United States $25 billion per year from crime‐​related activity, $13 billion for collisions, and $28 billion for health care. Yet these were dwarfed, it said, by what the CDC identified as another cost of alcohol to the economy: a reduction in workplace productivity, at $179 billion.

Now it’s simply wrong as a matter of economic logic to chalk up the vast bulk of this lost workplace productivity as a “cost to the economy.” If individuals’ alcohol consumption affects their work performance, the vast proportion of that cost is borne by the individuals themselves through worse employment prospects and lower wages. Some drinkers may prefer (hard as it is for public health campaigners to believe) a work‐​life balance where they stay out later to socialize and drink, rather than maximizing their at‐​work productivity. As such, acting on their preferences probably improves their economic welfare rather than detracting from it. That isn’t a “cost to the economy.”

But that’s really an aside from my central point here. For, confronted with this retort, some economists and politicians will reply, “but with lower productivity and so lower wages, the drinker in question will be paying less in tax or getting more in transfers from means-tested government benefits. So there is another externality - a fiscal externality: the productivity effect means his or her net contributions to the government’s finances will fall. That means other people will either see higher taxes or less in the way of government spending, now or in future, to pay for his or her decision to drink. Any intervention must account for this negative externality too.”

This type of argument is common. In the UK, the government regularly pushes health policies, like smoking restrictions and sugar taxes, on the basis they will reduce the demands on the National Health Service—improving the public finances. Campaigners pushing childcare subsidies around the world say that lowering the out-of-pocket costs of childcare will enable mothers to “fulfil their potential” in the labor market, and that mothers will see higher lifetime productivity, improving the public finances again.

That such third-party fiscal effects exist is undeniable. But I want to argue that this effect is not an externality, in the normal sense, and, in any case, shouldn’t factor into such specific policy considerations.

Economists typically reject, for example, the need to correct for “pecuniary externalities.” If my income suddenly surges and I buy tons of one good, I might marginally drive up the good’s market price, harming other customers. But, in the round, the market outcomes from the price changes are still efficient, and so we rightly ignore these spillovers.

Fiscal externalities - how someone’s behavior affects others’ net tax burdens - are best thought of as a function of how governments set eligibility for programs and raise revenue. That makes fiscal externalities more pecuniary than “real.” My drinking excessive alcohol may jumble the net price that each household pays for government. But that mainly reflects how government is structured - we needn’t have the state tax and spend in that way. Indeed, there’s no underlying reason why we should assume an inefficiency from such a fiscal externality here. Even if an inefficiency exists, it may be better to change the whole government tax and spending system towards more individual responsibility, rather than then seek to deal with the fiscal externality.

Most people I’ve made this wonky argument to have not been persuaded. Fiscal externalities seem intuitive, even to many economists. But even if you don’t agree with me on the point above, there’s a more compelling logic: legitimizing the correction of fiscal externalities as a reasonable government goal would necessitate intolerable new interventions right across our lives.

Think about it: it’s weird to constrain concern about people’s net tax contributions to just the impacts of their smoking, drinking, or childcare decisions. Many other decisions throughout our lives affect our measured productivity, wage levels, and so net tax receipts, so influencing net taxes paid by others. To say that government should try to solve for fiscal externalities is really to say a role of the state is to maximize each individual’s net contributions to government, which is obviously absurd.

Taking time off to have children or to care for a sick relative, for example, may lower my net tax contribution. Regularly staying up late to watch TV and being tired at work, the same. In fact, that decision not to invest in going to get an MBA may reduce my measured productivity and lifetime net tax contributions too. Should the government institute policies to penalize all of these decisions? How would they go about it?

What about people’s career choices? Opting to become a French teacher or a public‐​interest lawyer, so forgoing the opportunity to become a Wall Street trader, would be a decision that failed to maximize one’s net tax contributions, potentially leading others to pay more. Retiring early or taking a gap year? The same. Should these decisions be disincentivized through government policies? Or how about where people choose to locate for work? That definitely affects earnings potential and so one’s net contributions to the federal balance sheet.

Until now, we’ve largely decided that, in a free society, such decisions are a matter of personal free choice. Singling out the productivity and public finance effects of alcohol consumption or mothers’ labor force participation as unique externalities in need of correction would therefore be totally arbitrary. Every day individuals make decisions that affect their productive potential and, indirectly, their net tax contributions, and so those of others. Choosing to intervene to correct some of them and not others would necessarily amount to nanny statism dressed up in a faux economic logic.

On a pragmatic basis, if nothing else, we’d therefore be better of just ignoring fiscal externalities entirely.