Summer School 2: How taxes change behavior and the economy

Summary

Planet Money Summer School 2: How Taxes Change Behavior and the Economy

Episode Release Date: July 16, 2025
Host: Robert Smith
Guest Expert: Professor Derek Hamilton, Henry Cohen Professor of Economics and Urban Policy at the New School

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Introduction to the Role of Government in the Economy

Robert Smith kicks off the episode by framing taxes not just as a means for the government to raise revenue but as powerful tools that can shape economic behavior and societal values. He emphasizes the evolving nature of taxation from its early uses, such as tariffs on imported goods and property taxes, to more complex instruments like corporate and sales taxes introduced in the early 1900s.

Robert Smith [00:34]: "We all know this, right? Fund the military, insurance programs like Medicare and Medicaid, roads, bridges, all the stuff. That part is pretty straightforward."

Key Topics Covered:

• Revenue Generation: Traditional view of taxes funding government expenditures.
• Behavioral Influence: Modern perspective on taxes altering economic actions and societal norms.
• Tax Code Complexity: How deductions and incentives within the tax system guide personal and corporate behavior.

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Case Study: The Earned Income Tax Credit (EITC)

Professor Derek Hamilton delves into the EITC as a prime example of taxes being used to redistribute income and encourage work. The discussion highlights the EITC's design to provide financial bonuses to low-income workers, thereby uplifting them economically.

Derek Hamilton [04:35]: "And you are describing the ways in which we structure behavior and frankly structure inequality by way of our tax code."

The episode features narratives from individuals like Lynn Matthews and Mariano Choa, illustrating the tangible impacts of the EITC on their lives. These stories underscore how the EITC not only provides immediate financial relief but also facilitates long-term economic advancement through education and improved living conditions.

Mariano Choa [13:50]: "No, no, no, no. Because my income is low. It's low income."

Key Insights:

• EITC as a Redistribution Tool: Transfers cash to low-income individuals, effectively redistributing wealth.
• Incentivizing Employment: Encourages recipients to maintain or increase their income without losing benefits abruptly.
• Economic and Social Mobility: Facilitates access to education, better housing, and debt repayment.

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Understanding Progressive and Regressive Taxes

The episode contrasts progressive and regressive taxation systems, explaining how they differently impact various income groups based on the economic principle of marginal utility.

Professor Derek Hamilton [18:27]: "A flat tax is a regressive tax."

Definitions:

• Progressive Taxation: Higher earners pay a larger percentage of their income in taxes, reflecting the lower marginal utility of additional income to them.

  Derek Hamilton [36:55]: "Progressive taxation would suggest that those who can least afford to pay the tax pay a lower rate than those who can most afford to pay it."

• Regressive Taxation: Lower earners pay a higher percentage of their income, placing a greater relative burden on them.

  Derek Hamilton [18:29]: "Everybody pays 12% of their income. That's regressive because some people just have lower incomes."

Discussion Points:

• Marginal Utility: Additional dollars have greater value to lower-income individuals compared to the wealthy.
• Policy Implications: Progressive taxes aim to align tax burdens with individuals' ability to pay, promoting economic equity.

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Pigouvian Taxes and Addressing Externalities

A significant portion of the episode is dedicated to Pigouvian taxes, named after economist Arthur Pigou, which are designed to correct negative externalities—unintended adverse effects of economic activities on third parties.

Historical Context:

• Arthur Pigou's Contribution: Introduced the concept of negative externalities and proposed taxes to internalize these external costs.

  NPR [27:26]: "He was the person who gave us this whole framework for thinking about negative externalities."

Case Studies:

• London Fog and Pollution: Pigou identified the societal costs of air pollution from coal burning, such as health issues and property damage, which were not accounted for by the polluters.

  NPR [30:49]: "That's his famous graph. And what this graph said for the first time to the whole entire world was that you had to put a price on these problems or they would never be solved."

• Modern Applications: Carbon taxes in countries like Canada and New Zealand, and congestion taxes in Manhattan, which have successfully reduced traffic and pollution while funding public transit improvements.

  Robert Smith [32:26]: "We have this progressive income tax code in the United States, and maybe you can say we do it because it's the right thing to do. But there's an economic way to think about progressive taxation, and that's through this concept called marginal utility."

Challenges and Unintended Consequences:

• Measurement Difficulties: Accurately quantifying the societal cost of externalities remains complex.

  Mariano Choa [31:05]: "You could calculate that cost and force the guilty parties to pay for it."

• Behavioral Shifts: Taxes may lead to unintended shifts in behavior, such as consumers opting for alternative harmful products when one is taxed.

  Robert Smith [34:08]: "One way is that people find a way to avoid the taxes. Maybe they don't have a sugary drink, but they spend it on something else that's bad for them."

Notable Quotes:

Derek Hamilton [34:00]: "You always have to think with these taxes. You're not just discouraging one thing, you may be encouraging people to shift to another thing."

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Vocabulary and Economic Concepts

The episode concludes by reinforcing key economic terms that underpin the discussion on taxation:

• Progressive Taxation: Higher earners pay a higher percentage of their income.
• Marginal Utility: The additional satisfaction or value derived from an extra unit of a good or service.
• Negative Externality: An adverse effect of an economic activity on unrelated third parties.
• Pigouvian Tax: A tax imposed on activities that generate negative externalities to correct an inefficient market outcome.

Example Illustration:

• Junk Mail Tax: Professor Hamilton humorously suggests taxing junk mail to address the societal costs of wasted time and environmental impact from recycling.

  Derek Hamilton [35:29]: "Stop sending me junk mail."

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Conclusion and Takeaways

Robert Smith wraps up the episode by highlighting how taxes, when thoughtfully designed, can be powerful instruments for social and economic change. From redistributing income through the EITC to addressing environmental issues with Pigouvian taxes, the episode underscores the multifaceted role of taxation in shaping a more equitable and sustainable economy.

Robert Smith [38:05]: "The way to fix a negative externality is a Pigouvian tax. Put the real cost of societal harm into the price of the product and let the market decide if it's worth it."

Final Thoughts:

• Tax Policy as a Reflection of Societal Values: The choices embedded in tax codes mirror what a society prioritizes and values.
• Economic and Social Empowerment: Properly structured taxes can empower individuals, promote fairness, and address collective challenges.

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Stay Tuned:
Next week's episode will delve into government spending choices and the economic principles guiding where tax revenue is allocated.

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This summary is based on the transcript provided and aims to encapsulate the key discussions and insights shared during the "Summer School 2: How Taxes Change Behavior and the Economy" episode of Planet Money.

Transcript

[Robert Smith]

Hey, everyone, just a quick message before class gets started. Planet Money Summer School is having a live graduation ceremony and party in New York City on August 18th. It's going to be great, so get your tickets now before the show sells out. Planet Money plus supporters get a 10% discount and get early access to summer school episodes all summer long. Check out the show notes for a link to buy tickets and to subscribe to Planet Money Plus.

[NPR]

This is Planet Money from npr.

[Robert Smith]

Welcome back, class, to Planet Money Summer School. The only economics degree that comes with UV protection for the beach. SPF 50. This season. We're talking about political economy, which is a fancy way of saying the role that the government has in our economy. And if you've been paying attention these days, you might have noticed that the government is all up in every part of our business. Today is class number two taxing our way to a brighter tomorrow. I'm Robert Smith. One big reason to pay attention to what the government is doing is because they are doing it with our money. We ask more of our government, and then they ask more of us through our taxes. At the very beginning of our country, Congress was desperate for money. They levied taxes on imported goods. Yes, a tariff is a tax on things like whiskey. States taxed property. The first income taxes came to pay for the Civil War. Corporate taxes and sales taxes appeared in the early 1900s. The main thing taxes do is raise money. We all know this, right? Fund the military, insurance programs like Medicare and Medicaid, roads, bridges, all the stuff. That part is pretty straightforward. The more money you raise in taxes, the more you can spend without borrowing a ton of extra money. Today in class, we wanted to zero in on a different way to think about taxes as a tool to shape the economy. Taxes can be used to redistribute income to those who need it the most. Taxes can stimulate or slow economic growth. Taxes can be used to influence our habits and maybe even save the planet. With great taxing power comes great responsibility. That's why some of us love to talk about taxes.

[Derek Hamilton]

Well, as a person, I probably don't love taxes, but as an econ professor, absolutely. It is our biggest fiscal tool.

[Robert Smith]

Hey, before you jump in, you have to introduce yourself to the class.

[Derek Hamilton]

Oh, man, I quit. I'm out. So, my name is Derek Hamilton. I am a university professor and the Henry Cohen professor of Economics and Urban Policy at the New School.

[Robert Smith]

And.

[Derek Hamilton]

And I run an institute on race, power and political economy, also at the New School.

[Robert Smith]

So, taxes, ultimate tool of government. How does it work? How does the Tax code change our behavior. How does it change society?

[Derek Hamilton]

It certainly changes behaviors. It can incentivize various things. For example, if we offer a tax rebate or subsidy for people to green their house, to convert from gas furnace to electric furnace, well, that's a change in behavior that presumably is good for the environment. Not presumably is actually good for the environment.

[Robert Smith]

And the government's also making choices when it has things like deductions. Right. It seems like, oh, deductions. It's just something I do on my tax forms. But they have made specific ideas that we want to let you keep that money so you will spend it for a specific purpose that we want you to spend it for. And famously, in the United States of America, we have a deduction you can take for interest you pay on your home mortgage, which encourages people to own homes rather than rent them.

[Derek Hamilton]

Exactly right. I mean, we have a society that a lot of people not only live in their home. Many Americans use their home as a mechanism to save, a mechanism to grow their wealth. And the tax code has incentivized that.

[Robert Smith]

And with every change in the tax code, there are winners and losers. I always think of the different ways we tax forms of income. You know, a dollar isn't always a dollar. So a dollar made by a corporation that may, you know, after accounting, get no taxes. A dollar made by selling something, capital gains gets maybe a low tax rate. But a dollar at my job, at least the most recent dollar gets taxed at a pretty high rate.

[Derek Hamilton]

Exactly. And you are describing the ways in which we structure behavior and frankly structure inequality by way of our tax code. So taxes reflect value, they reflect societal value. So if we tax wages at some rate, and then we tax, say, capital gains, which is a form of income that's generated from owning an asset.

[Robert Smith]

Yes. Selling stocks, for instance.

[Derek Hamilton]

Selling stocks. Well, if we tax stocks at a different rate than we tax wages, that's reflective of values. Both of them generate revenue. But you could imagine that some people have greater access to wages versus some people have a greater wealth by way of reaping the rewards from, say, stocks. Dividends from stocks.

[Robert Smith]

Well, over the course of today's class, we're going to hone in on some of the different reasons and ways that the tax code can change behavior both for the good and for the bad, and remake society, as you say, Derek, in the form of our own values. There it is after the break.

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[Robert Smith]

Our first case study in this summer school class deals with taxes as a way to redistribute income. We often think of taxes as taking money out of our pockets, but for some people, it's the exact opposite.

[Derek Hamilton]

The tax code is a mechanism by which government can literally put money in the hands of people.

[Robert Smith]

But it gets to choose which people.

[Derek Hamilton]

And it gets to choose which people.

[Robert Smith]

And the way it pulls off this trick makes all the difference. As we will learn in this classic Planet Money episode from 2013, hosted by Hanna Jaffe, Walt and Marianne McCune, Tax.

[Hanna Jaffe]

Day is coming up. People love to complain about it, but not this woman.

[Robert Smith]

Yay. I'm so happy.

[Hanna Jaffe]

That is Lynn Matthews. She's a FedEx package handler, and I met her at a pro bono tax center in Newark, New Jersey. When she stopped in to get help filing her return. She was even singing while she waited. And that's because for Matthews, tax time is bonus time. For people like her, that bonus can be a big it can be more than $5,000. Often it's more than you paid in taxes for the entire year. Lynn Matthews is one of nearly 30 million people who receive this bonus. It doesn't sound exciting when you see it on the tax form. It's got a very technical, kind of boring sounding name. It's the Earned Income tax credit, but Lynn Matthews doesn't find it boring at all.

[Derek Hamilton]

Earned.

[Robert Smith]

Credit. I'm so happy. I'm happy.

[Derek Hamilton]

Yay.

[Richard Berkhauser]

The Earned Income Tax credit is one of the biggest cash transfers we have in this country. More than $60 billion last year handed from wealthier Americans to poorer Americans. You'd think there'd be a lot of discussion about this, right?

[Hanna Jaffe]

Right.

[Richard Berkhauser]

And yet the surprising thing is almost everyone who looks at the earned income Tax credit. The EITC pretty much likes it, right?

[Hanna Jaffe]

That's exactly right. It's been expanded by every president, right and left, since the 1970s. I'm talking Reagan, Clinton, both Bush's and Obama. As I was reporting the story, I talked to more than half a dozen economists, left and right, and pretty much all of them said that the Earned Income Tax Credit does exactly what it was designed to do. The architects of the EITC wanted to help poor people and at the same time, encourage them to work.

[Marianne McCune]

And by God, they did. It worked. You know, the rocket was launched and it hit the moon.

[Hanna Jaffe]

This is Richard Berkhauser of Cornell University, and he told me that you do not see that kind of success very often when it comes to programs for the poor.

[Marianne McCune]

I'm not exaggerating when I'm telling you, look, I've been doing public policy since the 1970s, and there's not a hell of a lot of these programs where you can see the tremendous change in the behavior of people in exactly the way that all of us hoped it would happen.

[Richard Berkhauser]

So, Marian, can you just lay out how it works?

[Hanna Jaffe]

Okay. So very simply, the US Government says, if you work but you're still poor, we're going to give you a bonus. And if you have kids, it's going to be a big bonus, a big chunk of money. It could be more than a third of what you made all year. And it comes in one big lump sum.

[Robert Smith]

Review, please.

[Hanna Jaffe]

When I was at the Tax center in Newark, I met this woman named Mariano Choa. And she says she still remembers the first time that she got it.

[Mariano Choa]

I say, are you serious?

[Hanna Jaffe]

This is, for me, it was about $3,000. And that's after making only about 9,000 the whole year. Working part time at a bank and living on $9,000, that is really hard. Ochoa had to seriously save every penny of her money. She told me that on her long commute to work, she remembers going past this one McDonald's every day and smelling the French fries, but telling herself, you.

[Mariano Choa]

Have to say no, because I have to pay my rent.

[Hanna Jaffe]

Living on $9,000 is clearly very difficult. And if you want to design a policy that's going to help poor people, giving them 3,000 more, that seems like a pretty intuitive thing to do. But the eitc, the more you learn about it, the more counterintuitive it seems.

[Richard Berkhauser]

So let's just walk through this. So imagine the way American policymakers have thought throughout history about helping poor people. You imagine the poorer someone is, the more help they need, so the more money you want to give them. So, for example, you get food stamps, or you get subsidized housing. You get free government health insurance if you're poor. And if you start working and make enough money, you get kicked off food stamps, or you get kicked out of your housing, or you no longer have government health insurance because you no longer have need. And for most of us, we look at that and say that makes a lot of sense. And there's certainly lots of good arguments for why these programs are useful. But when economists look at that, they see something different. They see that you're actually paying people to stay poor.

[Hanna Jaffe]

Right? So when they designed the earned income tax credit, economists were coming from a totally different direction. They did an economist mind flip. They said if the ultimate goal is to help people move up the economic ladder, then you have to pay them to move up the economic ladder. Somebody like Mariano Choa, when she made $9,000, she got a $3,000 bonus. When she made $15,000, four years later, she got $4,000 from the EITC.

[Richard Berkhauser]

Then that's the sort of economist mind flip, right? Is the more you make, the more the EITC pays you. And that's a pretty radical change. It was in the 90s that the EITC was created in a big way. Right. And that was when we were reforming welfare as we know it. So welfare up until that point had, for the most part, given people money because they proved that they had need. And then it would take that money away if they started working and made too much money. So the EITC was this new approach to that problem.

[Hanna Jaffe]

Yeah, it's this very delicately designed equation. You start out, you make more and more money, you get bigger and bigger bonuses, and then at some point, you peak somewhere, say, between 12 and $20,000, depending on how many kids you have. And then the bonuses start to get smaller again.

[Richard Berkhauser]

But even when the bonuses are getting smaller again, they're not getting smaller so quickly that it makes you want to stay at a smaller salary.

[Hanna Jaffe]

Right? And for Ochoa, this was like magic. When she first started getting the eitc, she was working part time. She was caring for a son who was in special ed. She was on food stamps, and she was in debt from her divorce. And since then, with help from the eitc, she has paid her debt, she's gotten off food stamps. She went to school for accounting. And when she was unhappy with the Newark high school her son was gonna have to enroll in, she managed to even move to a better school district.

[Mariano Choa]

I found the apartment there and I changed my life.

[Hanna Jaffe]

Could you have moved to a nicer neighborhood with nicer schools without the earned income tax credit?

[Mariano Choa]

No, no, no, no. Because my income is low. It's low income.

[Richard Berkhauser]

Okay, so we've got this delicately designed equation that actually pays you more the more money you make to help you move up the economic ladder. And, and then we have the second magic ingredient that makes the earned income tax credit so successful. And the second is that it just pays you cash. It follows a very simple idea that economists love, which is that the best way to help poor people is to give them cash and trust them how to spend it best. And this kind of aid to poor families in economics is called a cash transfer. And, and right now, the majority of the assistance the government offers to poor people is not cash. We're not spending a lot of time handing over cash. The government is giving poor people things like health care or vouchers for housing, food stamps, things called in kind transfers.

[Hanna Jaffe]

There are a lot of economists out there who really prefer the cash transfers to the in kind transfers. And it's not just economists. If you ask someone like Reo Sorio, recent father of these two twin boys, you hear napping loudly in his living room, cash is the only kind of help he wants.

[Reo Sorio]

I know, I know how to spend it for everybody. I can't speak for everyone else. I'm not sure.

[Hanna Jaffe]

What he needed was some cash to invest in his business. He wanted to start a luxury car service, get a fancy ride to shuttle around actors and diplomats. And he knew a lot of people like that because of his years working in the hotel industry. So when his twins were born, he actually cashed out his 401k to buy this fancy car. He started his business and is going along but slowly. And he had just run out of all of his savings when he found out that he qualified for the earned income tax credit this year. And he said he was, quote, delighted.

[Reo Sorio]

I was like, wow, that's incredible. That's a really nice number.

[Hanna Jaffe]

That's more than a third of what you made last year here, right?

[Reo Sorio]

Definitely is. And it was incredible.

[Hanna Jaffe]

So you're like, woo, we're going on vacation.

[Reo Sorio]

Not at all, not at all. I'm just looking down. I'm just trying to focus on the future. Hopefully my business will bring me plenty of vacations later on down the line.

[Hanna Jaffe]

So we've got two EITC poster children here, Ochoa and Osorio, and there are millions more whose lives have really and truly been changed by this policy. But before we get too happy, Hannah, I do need to say that the EITC doesn't solve every problem. First of all, it only helps people who are working. If you don't or can't work, there's nothing in it for you. Some people that should get it don't. And some people game the system. They get it when they shouldn't. And there are a lot of economists who argue that if you didn't have in kind transfers like food stamps or government healthcare, the EITC wouldn't be so successful. It has to exist alongside those other.

[Richard Berkhauser]

Programs because people, a lot of people who are on EITC are also getting food stamps or getting those kinds of supports as well at the same time.

[Hanna Jaffe]

Yes, it's different in every state, but certainly people benefit from both at the same time.

[Richard Berkhauser]

Okay, so maybe those things help the EITC be super successful.

[Hanna Jaffe]

But still, the things that economists love about it, those things really do work.

[Robert Smith]

Marianne McCune and Hana Jaffe Walt from 2000. In the United States and all around the world, the rich get taxed at a higher rate than the poor. But it took a while in the United States to come around to this sort of system that we have now. The founders of the United States did not include the idea of an income tax in the Constitution. And it wasn't until the Constitution was amended in 1913 that we got what we know as a permanent progressive tax system. Professor Derek Hamilton. What, what does that mean?

[Derek Hamilton]

It's progressive.

[Robert Smith]

And you know, this doesn't mean politically progressive. It means economically progressive.

[Derek Hamilton]

Essentially. It means the more you have, the higher the tax rate you have to pay.

[Robert Smith]

And in the old days there was this really wide range. If someone was poor, they would maybe not pay anything in taxes. But for the very richest of Americans at a certain point during the last century, I think their marginal tax rate was up to 70% on that very last dollar that they earned. This is a classic example, a progressive tax code. But some American taxes are regressive. What's a regressive tax and what's an example of that?

[Derek Hamilton]

A flat tax is a regressive tax.

[Robert Smith]

Everybody pays 12%.

[Derek Hamilton]

Everybody pays 12% of their income. That's regressive because some people just have lower incomes. When we think about consumption taxes, those are regressive taxes.

[Robert Smith]

Consumption taxes meaning like sales tax, a sales tax. Everybody who buys a bagel in New York City pays. I think it's like almost 9% of the price tag.

[Derek Hamilton]

Something in there getting up there 9%.

[Robert Smith]

On a bagel doesn't mean very much to me, perhaps, but it might mean a lot to somebody who's making a very low wage.

[Derek Hamilton]

Yeah. If a bagel costs $10, that dollar that goes towards taxes for somebody who earns $1,000 a week is much less than somebody who earns $100 a week.

[Robert Smith]

So we have this progressive income tax code in the United States, and maybe you can say we do it because it's the right thing to do. But there's an economic way to think about progressive taxation, and that's through this concept called marginal utility. Marginal utility is the use that you get out of every extra dollar. Let's just say, you know, you hand me a dollar, put in my pocket, maybe send it through the wash, maybe put it in the bank account. I won't necessarily spend it because I have extra money, or you hoard it.

[Derek Hamilton]

You save it away.

[Robert Smith]

Or if you give a single dollar to someone who is making below average wages, they're more likely to spend it, or as we heard in the story, invest in their business or even go to Disneyland. How does this marginal utility play into thinking about taxes? Is it literally that, like, a dollar means less to me than it does to them?

[Derek Hamilton]

You know, the concept of marginal utility is often thought about in an individual perspective. And indeed, there is this other concept in economics called diminishing returns.

[Robert Smith]

Explain that.

[Derek Hamilton]

It simply means the more you have of something, having an additional unit of it at some point begins to tail off in terms of increasing value to you. So we can give a simple example. If you have $100 and you get an additional dollar, well, going from 100 to 100, $1 might be less valuable to you than going from, say, $1 and getting an additional dollar don't make money. And we can think of it in a literal sense in terms of being able to simply buy things when you want to buy food, for example, if you have a whole lot of money, getting an additional dollar is not going to make that much of a difference in your consumption habit for food. But if you're lower income, getting additional dollars or an additional dollar will indeed lead to a bigger effect in terms of what you can actually consume.

[Robert Smith]

So if you're building a tax code and you know this economic principle, do you literally think, well, not that I'm taking from the rich and giving to the poor, but you're thinking like a dollar means less to a rich person than it does to a poor person?

[Derek Hamilton]

Well, if you ask them, they might tell you, no, it means the same to me. But also in economics, we know that revealed preference often happens through some behavioral thing. Don't tell me what you value, show me what you value. But we can go a little deeper, Robert. We actually get to define value. We actually get to use our tax code. We get to, as a society, make choices of what we value. So we may not like the fact that poor people simply don't have enough money to eat. So as a society, we can ensure that people have enough money to eat. And furthermore, not only will they have enough money to eat, they can use that additional money in ways to invest in their own productivity that becomes more valuable than that single $1 would have been to somebody who's already wealthy.

[Robert Smith]

And as we heard from the Earned Income Tax Credit story, people across the political spectrum, they're okay with that. Coming up on our taxing episode of Planet Money Summer School if the tax code can send money to the poor and even help them invest in their own futures, what other magical things can it do? Can it save the planet? After the break.

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[Robert Smith]

Podcast okay class, it's about to get nerdy in the summer school. We're going to talk about a debt economist, an impossible to understand equation, and somewhere in there a way that the government can Nudge businesses to do what's right for society. It's a case study from Sarah Gonzalez and Jacob Goldstein, and it's the story of Arthur Pigou and the thing that he invented called Pigouvian taxes.

[NPR]

Pigou was born in England in 1877.

[Marianne McCune]

Okay, sounds like the beginning of a story.

[NPR]

And for 35 years, Pigou was the only professor of economics at Cambridge University. And he started when he was really young, 30. Everything we know about Pigou is kind of patchworky, because Pigou didn't want us to know about him. Nahid Aslan Begi is a Pigou expert, has been studying pigou since the 80s. Wrote a book on Arthur Cecil Pigou.

[Mariano Choa]

I think he thought his life would be subject to a lot of scrutiny after his death, so he destroyed his private correspondence. He was a very private man.

[NPR]

Pigou loved the outdoors. He was a serious mountain climber. Would show up to fancy economics lunches in his climbing clothes or with an ice axe. And all of the.

[Marianne McCune]

That's compelling, that's tough.

[NPR]

But Pigou cared about the world and he cared about people. He cared about people living in poverty, kids working in factories. Maternity leave. He wanted mothers to get maternity leave 100 years ago.

[Mariano Choa]

Yes.

[NPR]

How progressive of Pigou.

[Mariano Choa]

Yes, he was a progressive, like a lot of the late Victorians.

[NPR]

So Pigou loved the outdoors. And he was living near London at this time, the early 1900s, when air pollution had become a huge problem.

[Marianne McCune]

They're burning coal, right? And it's like, you see those old pictures where it's like dark in the middle of the day. It's like worse pollution than you can imagine now.

[NPR]

Yeah. And the smog was called at the time, London fog. Some people called it pea soup.

[Mariano Choa]

It looked like pea soup. If you make split pea soup with yellow split peas, it was thick, it covered everything as an oily substance that covered furniture. Enter your rooms, you would breathe, killed people, it killed animals.

[NPR]

And Pigou thought about this not just as an outdoorsman, but as an economist. As an economist, he also saw the cost of London fog. He thought it would increase healthcare costs, it would affect vegetation, livestock. It would wreck your furniture. Everyone would have to buy new furniture. Everyone had to wash their clothes more often. Those are all costs. And the people burning the coal weren't going to be paying for this. Innocent bystanders would.

[Marianne McCune]

This is a problem economists have since come to call a negative externality.

[Robert Smith]

Right.

[Marianne McCune]

Negative because it's bad. It's negative. And external because it is some innocent third party being affected.

[NPR]

It's not the company burning the coal to make the product. And it's not the person buying the product, it's just all the random people who have to breathe the polluted air.

[Marianne McCune]

All the people who are external to the buying and selling of the product. And Pigou was the person who gave us this whole framework for thinking about negative externalities.

[NPR]

And to be clear, Pigou didn't like, discover that sometimes private companies do things that hurt society. But what Pigou did was come up with a solution to the problem. And he laid out this solution in this key graph in a book he published called wealth and Welfare.

[Marianne McCune]

And then, like, once that came out, everybody's like, great, Pigu, thanks. We get it.

[Robert Smith]

Yep.

[Hanna Jaffe]

Mm.

[NPR]

Instant fame. No economists of 1912, they weren't quite ready for Pigou's graph.

[Mariano Choa]

Well, they were baffled by it. Some people criticized it. And in the future editions of his book, I think he eliminated that graph. He didn't use it anymore.

[NPR]

He took it out.

[Mariano Choa]

He took it out because there were complaints.

[NPR]

What were they complaining about?

[Mariano Choa]

It was too complicated his vocabulary. You have to really work through it. Very hard to understand what he's saying.

[NPR]

Like anyone who writes anything in the.

[Mariano Choa]

Early 1900s, some are worse than others. I think his text is worse.

[NPR]

Oh, oh, okay. Interesting.

[Mariano Choa]

Yes.

[NPR]

Okay, so here Jacob is his terrible, not easy to understand graph.

[Robert Smith]

Okay?

[Marianne McCune]

Apart from this condition, on may be either greater or less than om according to the relations that subsist between the curves where on is blah, blah, blah. And then there is a graph that is just brutal, just totally unintelligible.

[NPR]

Yeah. And Nahid was basically like, you will never understand this graph.

[Robert Smith]

Okay, fair enough.

[Marianne McCune]

Give up now.

[NPR]

Don't even try. So luckily for us, like later on, economists simplified Pigou's famous graph. So here is the more easy to understand Pigou.

[Marianne McCune]

I'm waving my hands. Okay, we're doing graphs on the radio. Yes, it's hard, but we're planet money. We're going to do it.

[NPR]

Okay, so there's an X axis and a Y axis.

[Marianne McCune]

Yeah, the classic econ graphics. Vertical axis is price, the horizontal axis is quantity. Okay, so far so good. There's these two lines going up into the right basic, you know, positive slope lines on the graph. And one of them says pmc, which.

[NPR]

Is private marginal cost.

[Marianne McCune]

Okay, so private marginal cost. This is like the classic idea of cost, right? Like, let's go back to the Pigou London fog, early 1900s world. Sarah say you have a factory in London. You are burning coal to make your products. Whatever you're Making socks.

[NPR]

I'm making socks.

[Marianne McCune]

So this line, the private marginal cost line, is the cost for you to make socks in your coal burning, polluting factory.

[NPR]

That's the private marginal cost.

[Marianne McCune]

Okay? And then this other line says smc, smc.

[NPR]

That's the social marginal cost. And that would be the cost on society for me to make my socks.

[Marianne McCune]

So that one is not only the cost to you of whatever the wool and the labor and the machines, but also the cost of all of the pollution that your factory is emitting.

[NPR]

Exactly. That's the cost of everyone who gets sick from my pollution and everyone who has to wash their clothes and buy new furniture. That's the social cost. And in this graph, the social cost, the cost on society is higher than the private cost.

[Marianne McCune]

So another way to say this then is when there is a negative externality.

[Robert Smith]

Right.

[Marianne McCune]

When you're running your polluting factory to make your socks, the price you're selling those socks at is too low.

[Robert Smith]

Right?

[Marianne McCune]

Because if I'm buying your product, I'm paying just the private cost for those socks. But the real cost when you take into account externalities should be higher. The stocks that you're selling should be more expensive to take into account the cost of the pollution to society.

[Mariano Choa]

That's his famous graph.

[NPR]

And what this graph said for the first time to the whole entire world was that you had to put a price on these problems or they would never be solved.

[Mariano Choa]

You could calculate that cost and force the guilty parties to pay for it.

[NPR]

Like figure out how much London Fog is costing people and then force the companies burning the coal creating the London Fog to pay for it, not the innocent bystander. That's what makes it a Pigouvian tax. There are plenty of other taxes on things that seem bad, like cigarettes and alcohol. But those taxes are meant to prevent you, the drinker or smoker from drinking or smoking too much. It's not intended to do anything for innocent bystanders. If you want to put a Pigouvian style tax on alcohol, a government would have to say, okay, what problems does alcohol cause? Third parties Crime. When people drink more, they're more likely to commit crimes. Would a government have to say, okay, how much is crime costing us as a result of alcohol?

[Mariano Choa]

Yes.

[NPR]

So how do you know how much crime has been caused by alcohol?

[Mariano Choa]

Well, that's a million dollar question, isn't it?

[NPR]

It's really hard to measure how much crime brought on by alcohol specifically is costing taxpayers. Or how much smokers who get lung cancer and don't have health insurance Cost taxpayers or how much pollution costs society?

[Robert Smith]

Sarah Gonzalez and Jacob Goldstein from a show we did in 2019. This idea, the Pigouvian tax, was later used to develop carbon taxes in countries like Canada, New Zealand and Scandinavia. They figured out what burning fossil fuels cost society in terms of climate change and added that as a tax to companies that sell and produce those fuels. But there are other Pigouvian taxes. If you'd like to see see one in action, you can come drive. In New York City and Manhattan, there is a new congestion tax on cars who drive at a certain part of Manhattan which is meant to reduce the negative externality of crowded roads. Externalities like lost time, pollution, noisy streets. And guess what? After they put the tax in, travel times on the streets of Manhattan have improved. The extra tax money is being spent on public transit. We'll talk about how these taxes work and the unintended consequences with our professor after the break. So we are back with our professor, Derek Hamilton from the New School. Hey, Derek.

[Derek Hamilton]

Hey, dear.

[Robert Smith]

You're so excited by taxes.

[Derek Hamilton]

Oh, yeah, I get excited.

[Robert Smith]

Let's go to the very basic economic principle of using taxes to change behaviors, whether it's corporate or individual. Why does putting a tax on something.

[Derek Hamilton]

Create less of, makes something more or less expensive?

[Robert Smith]

It's pretty simple, right? It's like supply and demand and the government steps in and makes some things more expensive and some things less expensive.

[Derek Hamilton]

Yes.

[Robert Smith]

And we are more likely to do the thing that is less expensive.

[Derek Hamilton]

That's right.

[Robert Smith]

How does the government decide what it should put these taxes on in order to influence people?

[Derek Hamilton]

You know, you can make the negative externality argument by making the case that if somebody gets more sickly from the types of food they consume, like sugary drinks, that that becomes a burden on our healthcare system. But like all taxes, it's often done due to political process.

[Robert Smith]

These taxes often work, but there's ways in which they don't work. So one way is that people find a way to avoid the taxes. Maybe they don't have a sugary drink, but they spend it on something else that's bad for them. Right? So you always have to think with these taxes. You're not just discouraging one thing, you may be encouraging people to shift to another thing.

[Derek Hamilton]

We use the word unintended consequences. It might divert activity in one area, but sometimes that activity will reappear in other areas in ways that we may have intended and also unintended.

[Robert Smith]

People are so, so clever. I'm curious, professor, as you look around society, is there something that you think has a negative externality. It's creating problems for society that is not priced in that we should put a Pigouvian tax on.

[Derek Hamilton]

Well, frankly, I got a pet peeve with all the junk mail I get, both electronic and paper.

[Robert Smith]

We just had an election here. Yes.

[Derek Hamilton]

So from a personal perspective, I would love that there was not a zero cost of sending emails that I certainly don't want to read. And frankly, I wish we taxed some of the mass bulk mailing that I get on a daily basis and have to dispose of. And surely it's not good for the environment.

[Robert Smith]

This is genius. And we learned from this episode that you have to kind of work it out, like, what is the cost to society? How much time are you spending. Right. Going through junk mail? So we'd have to figure that society wide, we'd add that to the cost of sending junk mail. And then we'd have to like, figure out a way to maybe spend that money for alternatives. Right. So how could we spend that money if we tax these junk mailers?

[Derek Hamilton]

I mean, one way is we could use some of that money to help with our recycling costs.

[Robert Smith]

Exactly. That's great. I was going to say libraries so that people read more valuable material, but yeah, yeah, yeah. These are the sort of principles here of the Pigouvian tax.

[Derek Hamilton]

Exactly.

[Robert Smith]

One of the things we love to do here is vocabulary words. It's so funny. When I was in high school, I hated vocabulary words. But now, like, I do it for a living because I think it does focus us on what exactly can we take with us out into the world. From this episode, one of our very basic vocabulary words is progressive taxation. What does that mean?

[Derek Hamilton]

Progressive taxation would suggest that those who can least afford to pay the tax pay a lower rate than those who can most afford to pay it.

[Robert Smith]

Marginal utility. Oh, I feel like we're in Econ 101. What is marginal utility?

[Derek Hamilton]

I mean, utility is a concept to represent value and marginal is an additional item, a small change. So marginal utility, if we add them together, how does your value from the item change from one additional unit?

[Robert Smith]

If you've been in Econ 101, you know, they will bring up the example of pizza slices. By the time you get to the third or fourth slice, your marginal utility may be not as much from an extra slice of pizza. In the episode on Pigou, we talked about negative externalities. What's a negative externality?

[Derek Hamilton]

It's the additional cost borne onto society from some private actions.

[Robert Smith]

And the key is the private action is not priced into the product. You're basically getting the product for cheap because it doesn't factor in the terrible stuff it does.

[Derek Hamilton]

That's right.

[Robert Smith]

You don't know how many hours you are costing of Derek's time when you send him junk mail. It's a real societal cost.

[Derek Hamilton]

Stop sending me junk mail.

[Robert Smith]

And as our final vocabulary word, the way to fix a negative externality is a Pigouvian tax. Put the real cost of societal harm into the price of the product and let the market decide if it's worth it. Thanks so much. Derek Hamilton from the New School. It was great to have you in.

[Derek Hamilton]

Thank you, sir. Appreciate you.

[Robert Smith]

Students. Before you go, make sure you get your ticket to our live graduation event in New York city. It's on August 18th. You can wear a gown, bring your parents and compete to become the class of 2025 summer school valedictorian. Put that on your resume. It's on August 18th and the ticket info is in the show notes. Do it now. If you're a Planet Money plus subscriber, you get a discount and an access to time travel. Well, a very minor form of time travel. You get each summer school episode a week early next week on Summer School, we've done taxes. How about spending? Government makes a lot of choices about how to spend that tax money. Why does it pay for some things and not others? Coming up next week, Summer School is produced by Eric Mennell and edited by Alex Goldmark. It was fact checked by Emily Crawford and Ciara Wardez. Devin Meller is our project manager. Robert Smith, this is npr. Thanks for listening. Foreign.

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