Externalities are one of the most fundamental market failure justifications for government action, and Pigouvian taxes and subsidies are standard tools for correcting them. Even so, neither the legal nor the economic literature offers any comprehensive account of when policymakers should prefer taxes to subsidies or vice versa. This Article takes up that task. Prior efforts to distinguish between “carrots” and “sticks” have generally been limited to the context of pollution regulation, and I show here that even those efforts are incomplete. I also extend the analysis to the case of positive externalities, where there is little prior literature to speak of. Overall, I find that sticks are usually superior to carrots, but that there are some interesting exceptions.
Nonetheless, carrots are rampant in modern lawmaking, especially carrots in the form of tax expenditures. I identify features of modern politics and law that contribute to the current inefficient overproduction of carrots. Among others, I find that federalism contributes to political preferences for carrots. That implies an until-now unrecognized reason to centralize certain forms of government regulation.
Finally, I take issue with the claims of the environmental literature that carrots, even if the inferior policy choice, should be used when politics would be likely otherwise to frustrate any regulation. Using carrots in critical and closely contested situations only contributes to externality producers’ incentives to raise the political stakes, either by cranking out more negative externalities or withholding benefits.