Economics textbooks often teach that a proper role of government is to intervene in markets to align incentives when the market fails. Markets work best when decision-makers bear the consequences of their choices. “Internalizing externalities” — say, making companies that discharge pollutants into a river pay to maintain it — is cited as a just cause for taxes, subsidies, and regulation. Most economists continue to teach, write, speak, and podcast as if this textbook prescription for government intervention is a reliable-enough description of reality.
But real-world government intervention routinely does the opposite. It takes costs and benefits that individuals would otherwise experience as consequences of their own choices and shifts them onto other people. In other words, the government regularly “externalizes internalities,” for which we pay the price.
Income Redistribution and Welfare
The most obvious example is taxation for purposes of income redistribution. Whatever the merits or demerits of a policy of redistribution, the essence of any such policy is that some people (the net recipients of tax revenues) live partially at the expense of other people (the net payers of tax revenues). Consistent application of the economic logic that powers textbook explanations of externalities leads to the conclusion that government-engineered income redistribution causes too many people to seek such redistribution (chiefly, by exerting less effort than they otherwise would to increase their own earnings), while at the same time causing high-income earners to exert too little effort at earning taxable income.
Absent redistribution, each person would be paid as income an amount closer to the value of what he or she contributes to the market economy — meaning, the market causes each person to internalize the costs and benefits of whatever amount of effort they choose to devote to earning income. But redistribution obstructs this market result; it artificially dims both the personal penalty for not working and the personal reward for working.
Tariffs and Trade Wars
Another example of the externalization of internalities is protectionism. Producers’ earnings in competitive markets reflect roughly the value of that product to consumers. When consumers spend their own incomes in whatever peaceful ways they choose, they personally pay the costs and reap the benefits of their choices. Producers that better please consumers are rewarded with higher profits — higher profits voluntarily paid to them by consumers. Markets, in other words, internalize on producers the value of their efforts to please consumers.
Protectionist tariffs and non-tariff barriers, by contrast, externalize this internality. By shrinking consumers’ range of choices, protectionism artificially increases consumer demand for the outputs of protected producers. Protected producers thus earn higher profits without creating more value for consumers. A consequence that belonged inside the producer-consumer relationship has been transferred outside it.
Protected firms free-ride on a portion of their fellow citizens’ incomes — the funds these citizens would otherwise have spent on imports. As a result of protectionism, producers exert less effort than otherwise to please consumers. Far from correcting a market failure, protectionism distorts markets. Protectionism externalizes an internality.
Occupational Licensing
A third example of a government policy that externalizes an internality is occupational licensing requirements.
Adults spending their own money for their own purposes have every incentive to assess the quality of different service providers’ offerings. Service providers who seem likely to supply unacceptably low quality don’t win new customers and fade from the market. Surviving suppliers will earn revenue based on how much consumers value the service. In a free market, each service provider — hairbraider, electrician, carpenter, florist, interior designer — has incentives to satisfy consumers to increase his own income.
In a competitive market, in other words, service providers gain or lose according to their own efforts, and no consumer is obliged to pay more than is necessary for that service. The consequences of service providers’ choices (even as they impact the consumer post-purchase) are internalized by the service providers.
Occupational-licensing regulations externalize this internality. Obstructing consumers’ ability to choose different service providers, and blocking new entries to the market, these regulations artificially increase the incomes of licensed suppliers, as all consumers are forced to pay more. Competition forces providers to bear the consequences of disappointing consumers; restrictive licensing weakens that discipline.
When Government Makes Things ‘Free’
“Democratic Socialists” talk of providing for “free” the likes of tuition, bus rides, and childcare, along with subsidized groceries and other goodies. But obviously these goods and services do not become zero-cost simply by decree. What these socialists have in mind, instead, is to arrange for some people — bus riders relieved of ponying up fares — to free-ride on the productive efforts of other people (namely, net taxpayers). The more distant the rider is from the monetary cost of ridership, the more disordered are the choices and incentives.
The same incentives apply to subsidized college programs. When someone else pays, the cost of making a decision is far from the person making the choice.
It’s no exaggeration to describe the Democratic Socialists’ economic agenda as one that prevents individuals from experiencing the full benefits and costs of their personal choices — as one, in short, that externalizes internalities.
A clear-eyed survey of actual government policies reveals that the economics-textbook description of governments as internalizers of externalities is completely backwards.
