The Myth of Fiscal Externalities

Abstract

Many economists refer to phenomena whereby the behavior of people affects the cost of some subsidy or alters the revenues from some tax as externalities. The author refers to these as “fiscal externalities”; an example is smoking imposing costs on taxpayers due to the existence of subsidized medical care. This article shows that fiscal externalities do not necessarily imply any inefficiency, and when there is inefficiency, it is the result of the preexisting policy (the medical care subsidy) that creates the fiscal externality. Moreover, when there is inefficiency, the nature and magnitude of the fiscal externality is not a reliable guide to the appropriate corrective policy. For example, it will usually be best to modify the preexisting policy (the medical care subsidy) rather than tax smoking.