Corrective Taxation, Exclusivity, External Benefits, External Costs, Externalizing Internality, Government Failure, Internalizing Externality, Minimum Wage, National Defense, Public goods, Quotas, Regulatory Capture, Social Costs, Social Good, Subsidies, Takings, Wage floor
The headline describes a kind of government failure. In an ideal private transaction, costs and benefits are fully internalized by the buyer and seller. Both reap private gains, or surplus, from mutually beneficial transactions. On the other hand, there are cases in which external costs are inflicted on otherwise unrelated third parties, as when production emits pollutants. Or, there might be external benefits that inure to third parties, as when a homeowner pays to beautify their property and the whole neighborhood gains. These “externalities” are commonly citied as rationale for government interference in private markets. A good government, it is said, would seek to “internalize the externalities”, in one way or another, to prevent too much trade in a good imposing external costs, or too little trade where there are external benefits. Imposing taxes, granting subsidies, intervening with price controls, quotas, or various regulations are all ways in which corrective action might be attempted by public authorities.
The problem is that government often chooses badly, both misidentifying externalities, poorly estimating their magnitude, or in choosing how best to address them. When mistakes of this nature occur, the internal gains from trade are not just compromised or even destroyed. They are often externalized — revoked and redistributed to non-participants. The formerly private and internal gains may be extracted in the form of taxes, ultimately flowing to unconnected third parties. They are externalized internalizes, if I may coin a phrase. In other cases, in order to subsidize favored industries, individuals might be taxed on their income. Yet the favored industry is likely unconnected or external to the taxed individual’s source of income. While the gains that might accrue in the favored industry are internalized there, their source is an externalized internality.
Putting the troubling issue of takings or confiscation aside, these mistaken interventions distort relative prices and production decisions, with false signals propagating into other markets — which again are external effects. This, in turn, distorts the allocation of resources across various uses. These cases are clear-cut examples of externalized internalities.
I will confine this discussion to economic matters. By “internalities“, I mean all things within the economic realm that are private and/or reserved to the individual by natural rights. That includes private property and the individual’s freedom to trade and contract with others.
Wrongly taxing presumed “bads” or wrongly subsidizing presumed “goods” are absolute cases of externalizing internalities. And taxing a “bad” excessively (at more than its true social cost) or subsidizing a “good” excessively (at more than its true social benefit) are cases of externalizing internalities. The political temptation to subsidize might be the greater danger, as it is all too easy for public officials and politicians to identify and sell “deserving” causes, especially if they intimate that others will pay.
For example, subsidized education, which primarily benefits private individuals, is billed to the taxpaying public. It over-allocates resources to education, including students with greater value as human resources in other pursuits. Subsidized energy pays the seller of a power source more than its value to buyers, courtesy of taxpayers, and over allocates resources to those energy sources relative to non-subsidized energy and other goods.
Even if an industry is taxed in exact accordance with its true social cost, there is still the question of how the proceeds of the tax are to be distributed. Ideally, unless the social costs are borne equally by all, the distribution should bear some proportionality to the damages borne by individuals, yet that is seldom considered outside of certain kinds of litigation. The true victims will almost certainly be shorted. Benefits will accrue to many who are free of any burden inflicted by the undesired activity. The corrective action thus fails to properly address the externality, and it bestows an incidental external benefit on wholly unconnected parties.
Likewise, subsidies paid to an industry in exact accordance with its true social benefits require taxes that may burden individuals who do not stand to benefit from the subsidized activity in any way. That is true unless the industry in question produces a pure public good. Indeed, if the taxed individuals had a choice in the matter, they would often use the funds for something they value more highly. Thus, suboptimal distribution of the tax proceeds for funding a less-than-pure “social good” involves the extraction of an internality.
Other forms of government action have similar externalization of internal costs or benefits. With the imposition of a wage floor, or minimum wage, the least-skilled workers are likely to lose their jobs. Consumers are likely to pay higher prices as well. The job losers become more dependent on public aid, which must be funded via taxes on others. The wage floor will also degrade working conditions for those lucky enough to keep their jobs. All of these effects of market intervention demonstrate the public piercing of internal gains from private, voluntary trade. Some of what is excised gets spilt, and some gets siphoned off to external parties. Thus internalities are externalized.
Regulation of private industry often results in regulatory capture, whereby regulators impose rules with compliance costs too high for small competitors and potential entrants to afford. This obviously strengthens the market power of larger incumbents, who may in turn increase prices or skimp on quality. Taxpayers pay the regulators, consumers pay the inflated prices, smaller firms shut down, and resources are under-allocated to the product or service in question. These distortions spill into other markets as well. All these effects are part of the despoilment of internal gains from trade. To the extent that trades are prevented at competitive prices, the external winners are those who capture trades at higher prices, along with the regulators themselves and anyone else standing to benefit from graft as part of the arrangement. And again, the wrongful gains to the winners can be described as externalized internalities.
There are many other examples of government failure that fit the description of externalized internalities. In fact, extracting internalities is the very essence of taxation, though we readily accept its use for expenditures on goods that are of a truly public nature, which by definition confer benefits that are non-exclusive. The classic case, of course, is national defense. The differences in the cases of government failure cited above, however, are that the internalities extracted via taxation or other forms of intervention are externalized for private gain by other parties, no matter how widely distributed and diffuse. This is an extremely pernicious kind of government failure, as it ultimately leads to a cannibalization of private activity via our role as public actors. Beware politicians bearing gifts, and beware them just as much when they demonize private trade.