Taking welfare economics seriously


Arthur Pigou was pretty much the founder of welfare economics and it is from him that we get the idea of Pigou taxation (you can see that the branding company had to work overtime there, can't you?). The essentials of which are that where there is an externality we should either tax or subsidise it. By definition, externalities are not things contained within market prices. Thus if there is a negative externality (that is, a cost which is carried by someone not included in the market price) then there will be too much of that activity. Many forms of pollution are examples here. We reduce the excess amount of pollution by taxing it and thus incorporating it into those market prices: we thus get the socially optimal amount of pollution.

What few seem to recognise is that we use the opposite argument all the time: why should the taxpayer pay for the education of children? Because there is an externality, a benefit this time, in being part of a literate and numerate society (it's the lack of that numeracy and literacy which is the usual complaint about governments and education, not the taxes). Thus the society as a whole subsidises said education. Basic scientific research, there are innumerable things whose subsidy is justified in the same terms (public goods for example). Positive externalities should be subsidised.

Which brings us to the concept of bequests: should they be taxed or should they be subsidised? Is there a positive externality there or a negative one? It's appallingly difficult to see that someone getting Uncle Stan's money is a negative externality but is there a positive one there? Yes, according to this new paper, there is.

Uncle Stan, as his motivation to make the bequest, has only that warm glow from knowing that his nephew will be provided for. What is external to his decision is the very warm glow indeed that his nephew gets from being provided for. Thus we have an externality: Stan's decision is motivated purely by his utility, while there is a large utility gain to others not contained in the motives that lead to his decision. And as we've already said, positive externalities should be subsidised, not taxed.

Thus the truth is that far from inheritance tax being raised, or even existing, there should be a subsidy to add to each and every inheritance received.