Pigou Creates Losers

Research Seminars

On the Implausibility of Achieving Pareto Improvements from Efficiency-Enhancing Policies

Economic theory predicts that efficiency-enhancing policy changes can be made to benefit everyone through the use of lump-sum transfers that compensate anyone initially harmed by the change. Precise targeting of compensating transfers, however, may not be possible when agents are heterogeneous and the planner faces constraints on the design of transfers, due, for example, to asymmetric information. The paper presented in this Research Seminar derives an impossibility condition showing when Pareto improvements are not possible. The condition can be directly tested with readily available data. It relates the size of efficiency gains to the degree of predictability between initial burdens and variables used to condition transfers. The main empirical application is to a gasoline tax to correct carbon emissions, but the author presents related results for other sin taxes. Results indicate that it is infeasible to create a Pareto improvement from the taxation of these goods, and moreover that plausible policies are likely to leave a large fraction of households as net losers. The paper argues that the existence of these losers is relevant to policy design and may help explain political challenges faced by many efficient policies.