The externality problem is not limited to the financial sector. A classic example of this market failure would be a strip mining company that profitably extracts materials while subjecting its employees to unsafe working conditions and polluting a river where a large number of fisherman had earned a living catching fish. If the economic activity generated by the mine is less than the increase in workers' healthcare costs from unsafe working conditions (paid for by a third party insurer) and the loss of economic activity from the fishermens' inability to continue fishing ("paid for" by the fishermen) then even the most hardcore conservative cannot argue that we are better off by allowing the mining company to continue its activities. However, the historical liberal government response would be to try to pass a law that prevents the types of harmful mining activities that cause this specific external cost problem. But, regulation often has unintended consequences; if it is slightly too broad, it might prevent mining activities that would be beneficial and if it is slightly too narrow then mining companies will seek to exploit the loopholes to continue their damaging activities. Furthermore, there is an additional cost required to comply with increasingly complex rules that dampens growth. Also, if the punishment for a lack of compliance with the rule is merely a fine that amounts to less than the mining company's profits from continuing operations (when taking into account that there is a probability it could not be "caught"), it may decide to continue its acitivies and pay the fine rather than stopping its harmful activities.

That brings us to the current debate around taxes. The discussion has centered around how much people should pay in taxes and what share of the burden should be borne by taxpayers of different income leveles. Whereas conservatives argue for lower taxes that do not impose too much of a disproportionate burden on the wealthy, liberals argue that the wealthy who can afford to pay more should pay more. Again, I think this debate entirely misses the point. The problem should not be framed around who should bear the burden of funding the government; instead, the real issue at hand is how to ensure that some people are not able to extract value for themselves by causing losses to others or to the government, or by depleting common resources, and how to ensure that those engaging in activites that generate external benefits are rewarded. Instead of merely being thought of as a cost that must be borne by citizens to fund the government, taxes and subsidies should be the most important lever that the government can use to properly align individual and corporate incentives with collective goals. When used towards these ends, taxes and government spending can both promote economic growth by directly rewarding activities that are likely to generate long-term national increases in economic activity (activities that are economically beneficial to the system as a whole) and punishing those engaging in external cost activities by reallocating external costs back to those activities that cause them to be incurred.

Despite self-identifying as a liberal democrat, I believe this concept of the role of government is best thought of as "running the government like a conglomerate." A rational conglomerate with many different divisions engaged in business with parties both inside and outside of the firm is most interested in growing on a consolidated basis. If one division generates believes it has a project that can generate net profits of $1,000 but in the process will cause net costs to other interal divisions of $2,000 (that would otherwise not be incurred) to support its activities, management would not want to allow that project to proceed. However, rather than burdening management with trying to dictate every possible type of project that should or should not be performed through an enormously complex series of rules and regulations that cost departments money merely to understand and comply with (or stupidly not caring about interdepartmental costs at all), management would be more likely to track all costs and income at a departmental level and create incentives that encourage managers of individual departments to conduct business that improves their P&Ls inclusive of allocated costs. If department A causes department B to incur $1,000 of costs to support its activities, department A's net income for the purposes of calculating its P&L would be reduced by $1,000. Think of the government as the mangement of the conglomerate and the divisions as private businesses and individuals. In this system, the government plays neither the limited role envisioned by conservatives nor the parochial role preferred by liberals. Instead, it is merely ensuring that incentives are aligned by actively incentivizing activities that are net-positive to the system as a whole whlie actively penalizing activities that are net-negative to the system as a whole. Even the most hard-core conservative cannot argue against $100 of incremental government spending if it generates $100,000 of incremental private sector activity (i.e. DARPA funding the creation of the Internet).

The unintended consequences of a system like the one described are likely to be highly positive. For example, the discussion around how to get people to participate in activities that are beneficial to society but do not pay a high salary (external benefit) have always been answered with the argument that those people need to be paid more. But, in this system, those people's activities are likely to be rewarded while, at the same time, activities less beneficial to society (no external benefit or external cost) that those people could partake in are discouraged. As a result, the net pay differential between the more beneficial but lower paying activity and the higher paying but less benficial activity could be mitigated. Taxation and subsidies could no longer be assessed based on income tiers and politicians' pet projects but instead be based on the positive and negative externalities generated by each economic activity. The overriding objective is to promote domestic economic growth, ensuring fairness in that rewards are tied to economically and socially beneficial activities.

None of this represents a novel idea; the concept of "Pigovian taxes and subsidies" has been around for decades. In 2011, Michael Keen, a member of the IMF, actually published a paper entitled "Rethinking the Taxation of the Financial Sector", where he contemplates how Pigovian taxes can be used to effectively correct some of the misaligned incentives that led to the financial crisis. It is unconscionable that neither party has seriously considered how this approach can be used, at the very least, in the context of the financial services industry where it is likely easier to quantify the external costs and benefits than in other sectors of the economy. A group of economists (many of whom are conservatives), who are part of the informal "Pigou Club", have advocated for higher taxes on activities that result in negative externalities like a gas tax, pollution tax, and cigarette taxes; they believe that other taxes like the income tax could be reduced as a result. Taking these ideas to their natural conclusion, the government should not stop at penalizing negative externalities; it can use some of the revenue it generates from those taxes to reward activities that result in positive externalities.

Rather than Obama's plan to raise the income tax on those earning more than $250k/year, or the Republican proposal that would gut our social safety nets while reducing taxes for the wealthy, the Democrats should propose a reduction in the income tax rates coupled with a series of Pigovian taxes and subsidies that more than offset the decline in income tax receipts and thereby reduce the deficit. For us to remain competitive globally and avoid another crisis caused by negative externalities, our system of taxation and regulation must ensure that private incentives are not misaligned with the sytem-level effects that they have on our economy. The approach described here represents one possible solution to this problem.

--LAG