James Sallee “Pigou Creates Losers: On the Implausibility of Achieving Pareto Improvements from Efficiency-Enhancing Policies” (Revised September 2022) | WP-302R

Abstract:
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. In this paper, I derive 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 I present 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.