Preserving the environment has become an issue of increasing concern during the last few decades. The level of consumption maintained in developed countries requires a massive amount of petrochemicals, energy products, raw materials, and transportation to sustain. All of these industries have one thing in common: negative externalities.

When a coal plant burns coal, they create energy for consumers and consume coal from mining companies. This is a transaction seemingly contained within those parties. However, they also subsequently emit pollution into the air, a common resource. This is a negative externality.

 Dilbert understands negative externalities. 

Dilbert understands negative externalities. 

A common activity that creates a myriad of negative externalities is driving. Not only does driving create smog in cities, it also causes congestion on the roads and many fatal accidents—so much so that drivers pay much higher insurance premiums. It seems logical that if people drove less, we could avoid some of these negative externalities.

How do we encourage people to reduce negative externalities?

One of economists’ favorite ways to reduce negative externalities is through Pigovian taxes. Negative externalities are created when people (or companies) doing a thing don’t have to pay the full burden of doing so. If you didn’t get charged any money for burning lots of coal, why would you want to stop burning coal? As much as we would like to believe people want to conserve resources, it’s not true. When you don’t pay the full cost of something, you will over-consume it! We know people respond to incentives (Mankiw’s Principle #4), so, if we tax them so that they pay the full cost, they will reduce their consumption—thereby reducing the size of the negative externality. 

The Pigovian tax is therefor a tax correcting for a market failure—when the market fails to take into account the full costs of the transaction (negative externalities). Prominent economist Greg Mankiw is a huge proponent of Pigovian taxes, something that may stem back to his 10 Principles of Economics—see #7, “Governments can sometimes improve market outcomes”.

In Mankiw’s widely-read case for Pigovian Taxes, he focuses on the idea of a gasoline tax. To be specific, he suggests a $2 tax on gasoline—up from the tax of $.4 at the time of publication. To most people, this sounds insane! Gas prices are already very high. However, our roads are congested, insurance premiums and fatalities high, and cities polluted. If gas cost more, people would be more likely to carpool, take public transportation, or simply drive less. 

Even better, the revenue collected from gasoline taxes would (in Mankiw’s ideal situation) be used to reduce other distortionary taxes—like income taxes. As these taxes do not serve to reduce negative externalities, they only harm citizens. Society would improve as a whole if transportation became more efficient and individuals had more free income. You may remember that more savings = more investment in the economy. Sounds like a win-win!

But what about other methods of reducing negative externalities? Why can’t we use those?

Other ways of reducing negative externalities include “cap and trade” polices where the government issues carbon permits to companies, which they can then use or trade (sell). This creates a market for permits and reduces the cost to firms, as they can be rewarded for decreased emissions (selling permits). However, permits are usually allocated on a historical emissions basis, which creates incentives to increase emissions now in anticipation of future permit issuance.

From a global perspective, allocating permits for cap and trade would be contentious and unlikely to work. It is much more feasible to get non-OPEC (Organization of the Petroleum Exporting Countries) nations to agree on a global gasoline tax. Reduced demand for gas would lower the price of oil, allowing us to collect some revenue from OPEC countries.

Ok, sounds like an interesting idea, but do Pigovian taxes actually work?

London introduced a congestion charge in the center of the city over 10 years ago. Individuals have to pay for traveling in certain zones at busy times, with fees escalating the further you travel into the city center. 

It isn’t just a small tax—charges range from 9-12 pounds ($14.6-$19.47)! Not cheap, but it worked:

“According to [Transport for London] figures, traffic levels over the past 10 years have gone down by 10.2% but journey times for drivers have remained flat since 2007.” – BBC

Higher gas taxes are starting to sound more positive, right? Unfortunately, most people will never read this level of background on the idea, and simply flinch at the potential pocket-shock. The disparity between the most sensible policy and what politicians actually endorse is typically quite wide, and the topic of gasoline taxes is no exception. For now, we can hold Pigovian taxes as the ideal to which we should strive.¹

¹Obviously, this assumes you think we should reduce negative externalities. If you’re one of those “oh, it’s the next generation’s problem” type of people, you should try and forget you read this. Also, you’re the worst. 

AuthorIsabel Munson