Sallee, James “Pigou Creates Losers: On the Implausibility of Achieving Pareto Improvements from Efficiency-Enhancing Policies” (April 2019) | WP-302

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. In this paper, I derive a necessary condition for an efficiency-enhancing policy to create a Pareto improvement that can be tested directly with data. The condition relates the size of efficiency gains to the degree of predictability between initial burdens and variables used to determine a transfer scheme. This makes clear that compensation is a prediction problem. The paper moves beyond Pareto improvements and demonstrates how heterogeneity and predictability more generally impact a planner’s ability to control who ultimately loses and by how much and at what cost. The main empirical application is to a gasoline tax to correct carbon emissions. 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 the political challenges faced by many efficient policies.