Externalities have the appearance of side-effects as losses or gains for third parties. Without a clear mechanism for dealing with externalities, the causative agents of those remain detached from the side-effect losses or gains that they create. And that's a big problem, because then the incentives of those causative agents are misaligned with the general good of society. This may be one of the greatest, though relatively subtle, problems of our time. Let's try to solve the problem. We don't have much better things to do anyway.
The first part of the problem consists in operationalizing and measuring externalities. Is there a way to deal with externalities that represents them in an easy and appropriate manner? Unfortunately, this doesn't seem to be the case, since estimating the value of externalities requires a rather holistic perspective on the economy that's difficult to achieve. For example, the release of greenhouse gasses has global effects that are very much varied and hard to estimate. On the other hand, the creation and free access to digital goods represents a positive externality whose benefit is perhaps even more uncertain. How do you measure the value of a million freely available songs or books? Surely, you can't just go ahead and attribute a value equivalent to the market price of similar songs or books to those, since otherwise you'd end up in a situation in which every person with access to the internet would possess a value of hundreds of millions of dollars, or more. Perhaps that might not seem too inappropriate, but considering the real sitation that most people don't have so much money, they couldn't possibly pay for all the value they get for free, if free digital goods were said to have a value equivalent to market prices of non-free digital goods or equivalent material goods like books.
Excursion on the time/attention dimension
Then, we should also consider that nobody can even make use of freely available digital goods, even if they had a value that we'd estimate in the range of billions of dollars, because people only have a limited amount of time they can allocate to consuming such goods. The more goods are available on a certain (minimal) budget, the more dominant the scarcity of time or attention becomes relative to the scarcity of access. A digital society is dominated by an attention economy, not by a monetary economy! The relative value of time with respect to money is increasing, as we move towards digitizing our goods and services. Sure, there are ways to exchange money for additional time in many respects, for example by outsourcing daily chores and tasks to people who get paid for doing them, for example cleaning, caretaking, shopping, research, investment, and so on. But there are limits to this process. Nobody has more than 24 hours a day, and nobody can outsource the experience of reading a book, or decrease the time required to absorb its knowledge content below a minimal amount defined by the information throughput and processing capability of that person.
Time as measure of value
This excursion serves to demonstrate that it's hard to simplify the value of externalitites to a purely monetary dimension, since money plays a non-absolute and diminishing role in our economy. This stems from the fact that we can't pay people in "time" directly, since time is not fungible. Yet, if we accept this line of reasoning, we have to come to the conclusion that the problem of externalities cannot be solved, because externalities impacting the free access of time for third parties cannot be appropriately compensated. Well that remains true, unless we manage to develop technologies that can accelerate time for specific persons relative to the rest of the world! The only technology that would truly qualify for that would be substrate independent minds who could be accelerated nearly arbitrarily. For the sake of simplicity and convenience let's run with the counterfactual assumption that we possess such a speculative technology and the cost of time is linear with respect to its amount – such a basic assumption is also used in the book The Age of Em by Robin Hanson. In such a situation, we could see each unit of time as a unit of a universal currency. As we today measure the value of goods and services in dollars or Euros, we could measure their value in seconds or hours. In this sense, gaining an hour of time would mean getting your mind accelerated that you experience one hour of subjective time more than the general norm of society, since your mind is accelerated relative to it. Vice versa, a cost of an hour would mean that your mind runs slower, and you experience an hour less than "standard society".
The universality of the value of money depends on our level of technology
Does this framework help addressing the problem of externalities? Well, with the "fungible hour" we have a more universal measure of value than money nowadays. But of course, if we can trade hours, we can also trade them with money, so the real difference that the assumption of real fungibility of time makes, is to make money more universal as measure of value. If anything, this shows that the usefulness of money as representation of value is limited by our level of technology, rather than by any intrinsic shortcoming. So, let's assume that we could, in principle, measure the value of externalities in some form of currency, at least given a sufficiently high level of technology.
How would a direct solution look like?
Now, let's assume that we could precisely measure the cost or gain of any externality for any involved person. Then, we could imagine an institution that precisely transfers the cost or gain created for other persons to the causing person of that externality. That looks pretty much like a perfect solution to the problem of externalitites. What stops us from implementing such a solution is the sheer difficulty of implementing such a system. We cannot properly measure the costs or gains inflicted on other parties. We also cannot effectively coordinate to reflect those costs or gains back to the causative agents of the externalities, especially when those are global externalities. While we can assume that a ubiquitous sensor network and advanced artificial intelligences might be hugely helpful for solving the first problem, the second problem is a political one, since we don't have a universally accepted global externality compensation institution. Yet, this line of reasoning shows the necessity such an institution for implementing a straightforward solution to the problem of externalities.
Externalities as basis for basic incomes and merit-based incomes
Such a solution would imply that each person is compensated for the negative externalities caused by any other person. And also that any positive externality that one creates is reflected back to oneself as additional income. While the first could provide the basis for a negative externality based unconditional basic income, the latter would be the basis for additional incomes based on merit. In such a system taxation would become completely obsolete, respectively be replaced by a purely rational compensation system for externalities. The more we transition our real systems of taxation into that direction, the more appropriately can we deal with the problem of externalities.
Contemporarily possible approximations
Since we are still far away from being able to measure the value of externalities properly, or compensating everyone for externalities, we need to look at approximations for that solution that we could implement with our current levels of technology and political integration.
Carbon and land value taxes
The first approximation are taxes that are motivated by the idea of compensation for externalities. Examples for those are in particular carbon and land value taxes. Since everyone is affected by the cost of those externalities (in the second case as loss of the opportunity to make use of a certain piece of land for free), everyone should be compensated in the form of a universal basic income. In the case of carbon taxes, such an income should ideally be global in nature, perhaps most practically implementable with a digital currency, once the technological hurdles of getting everyone real access to those have been overcome. In the case of land value taxes, the income could be local in nature, since people usually prefer to make use of land in their (political) proximity.
Another possibility would be patients who make their medical data available for any interested researcher. This positive externality of available data should be reflected back to the patients who share it. Such an income would be a data-based income that perhaps may become high and universal enough to make universal health insurance obsolete – at least for those who opt in to such a system. Similar data incomes could be considered for personal data that people make available via social networks.
Usage based incomes
Digital goods can only provide value if they are actually consumed. Digital goods that lie around idle are pretty much worthless, with their only value stemming from their potential of being used. So, it seems to be rather rational to measure the use of digital goods and pay their creators in proportion to that use.
Donations and reputation incomes
One problem with the previous approach is that the subjective value of digital goods can vary dramatically. If people are able to express their preceived subjective value of the use of those digital goods directly, then that would be a solution that makes a lot more economic sense, as long as people are rational about their indication of subjective value, and actually care about doing that at all – boundary conditions which one cannot take for granted. Such appreciation of subjective value can form in the form of donations, or of product ratings. While the first approach is gaining in popularity via platforms such as Patreon, the latter could be translated into reputation-generated incomes with a system like Quantified Prestige.
Is inequality an externality?
And if yes, what kind of externatlity is it? One can argue that it's a positive externality, since it provides motivation for improving or maintaining one's status in society through intelligent effort (and therefore hopefully creating value for society which occasionally takes the form of positive externatlities). As long as we can't generate such motivation through technological means, that may remain a valid argument. On the other hand, high levels of inequality seem to come with societal problems with their own attached economic costs. In that case, inequality might be seen as negative externality. There may be a level of inequality that's "externality neutral", in the sense that its values as positive and as negative externality are exactly equal. In any case, in an economy that is based on the compensation of externalitites, inequality would be pushed back to this equilibrium point of externality neutrality through its externality compensation mechanisms. As side-effect the idea of externality compensation therefore results in a "natural" way to define "optimal" levels of inequality.
Certain kinds of basic incomes, additional incomes, merit-based and reputation-based incomes can be interpreted as externality compensation incomes. On the other hand, certain kinds of taxes like carbon taxes or land value taxes can be seen as externality compensation taxes. The intention to solve the problem of externalities in a rational way leads to the view of considering such interventions as desirable economic policies. The principle of externatlity compensation should be a pillar of the economics of the future.