Intro to Econ: Eleventh Lecture – Solutions to Negative Externalities through Taxation

In a previous post I explained why an economic activity that causes negative externalities (some form of harm for others) tend to be done “too much” in a market. With “too much” I mean that, without any other measures in place, the market will not generate a Pareto-efficient situation. Sometimes this is called a “market failure”. In this post and the next one I explain how we can deal with such situations and why this is easy in some cases and rather difficult in others.

Consider driving. What are the economic activities behind driving? The main ones are the buying, producing, and selling of cars to drive with and the buying, producing, and selling of petrol that most cars use to move. What are then the negative externalities associated with these economic activities? One can think of many. The first that comes to my mind is death. Death in the form of car accidents. Anyone who drives a car takes a certain risk that they will kill someone else. Another negative externality is pollution. In Graz, for instance, cars are partially responsible for the “Feinstaub” problem, the problem with fine dust (small particulate matter) in the air. Fossil fuels, and among these those we use in cars, are also partially responsible for the release of CO2 into the atmosphere, which seems to be a major factor in the change in climate that we have begun to see. This change in climate seems likely to affect most people adversely.

Does this mean we should stop driving? No, of course not. There are many benefits from driving, not only to the people who drive, but also to others. As I recall a succinct “advert” on a few trucks in Austria once “… with a truck. Or do you want to carry it yourself?” But it is quite possible (and seems likely) that people should drive less than they would do if all the prices for cars and petrol were determined through the market itself, as it seems that the negative externalities probably outweigh the positive ones.

Let me here focus on the first two externalities of driving. These (car accidents and small particulate matter – mostly from car tires but also from exhausts) are in fact largely unaffected by whether cars are operated using petrol or even the cleanest form of energy. So what could one do?

Well, it is actually quite easy. You can add a tax on cars and / or petrol. Such a tax would be expected to raise the price of cars and / or petrol. By the arguments made in the post on supply and demand (see post), derived from the idea that people prefer more money over less (keeping everything else the same), this should then lead to a lower demanded quantity of these products. People should buy less of these products and should, thus, drive less than in a situation without taxes.

This is in fact what most countries do. In Austria, for instance, there is currently (2019) a tax of 0,397 Euro per liter of the “most environmentally friendly” Diesel and of 0,482 Euro a liter of the “most environmentally friendly” normal petrol (Benzin). This means that at current prices almost half of the price of petrol is tax. There is the normal value added tax on cars, but in Austria as well as many other countries, there is also another tax on cars, in Austria the NOVA, which roughly speaking is higher the larger the (engine of the) car and is quite substantial.

It is of course not an easy question to answer whether these taxes are too low or too high for welfare in society overall. This is a tough empirical question which I will not pursue here. But clearly most countries have effectively (perhaps not perfectly) tackled the problem of externalities caused by driving for quite some time (and not only through taxes – there are also safety rules, et cetera).

I now want to explain how it happens that countries solve the negative externality problem through taxation. In a later post I then want to explain why reducing global CO2 emissions seem to be a harder challenge and why similar taxation measures can perhaps not be implemented so easily.

A country governed by a benevolent dictator (if there really ever are such people) would find it easy to impose just the right taxes on products carrying mostly negative externalities, such as cars and petrol. The benevolent dictator (supposing there are any) would simply implement this tax. Well, easy is perhaps too strong a word, because the benevolent dictator would first need to know (or be informed) what the societally optimal tax rate is. And, as I said before, this is a difficult empirical problem. But let’s ignore this for the moment.

So a benevolent dictator would choose the right level of taxes, but what about a democracy? Most countries don’t actually have such a direct democracy that the people would actually vote on such specific issues as the taxes on cars and petrol. But supposing they did, then they would probably vote on a reasonable tax on both. It is not clear whether they would vote for the societally optimal taxes, because in fact different people suffer differently from the negative externalities (in fact it is a bit unclear what the societally optimal taxes would be exactly), but one would expect that (because they understand these externalities) they would vote for a decent level of taxes on cars and petrol.

This is perhaps easiest seen using an analogy about safety measures (another way to affect driving). One could, for instance, imagine that everyone would be happy to be the only one exempt from speed limits (at least in some places) and yet that (almost) everyone would be happy to vote for tight speed limits for all (in cities for instance). This is no contradiction. It is just that people on the one hand value the freedom to drive at whatever speed they want to but also value that others drive slowly. If the only choices to vote on are speed limits for all, then the latter consideration probably dominates. And so people vote for speed limits. In much the same way people would vote for market correcting taxes on goods with negative externalities.

By the way, this reminds me of a recent debate in the US media that started with some super-wealthy people arguing that they should be taxed more. Some commentators suggested that these super-wealthy people, if they would be happy to pay more taxes, should simply donate more of their money to good causes (in fact many of them do donate substantial amounts of money). But I guess each individual super-wealthy person would prefer to pay taxes if all other super-wealthy people pay taxes than just doing it by themselves alone.

But I seem to be drifting off subject. I was arguing that political processes, such as voting, could possibly do a good job at determining a reasonable tax rate on goods with negative externalities such as cars and petrol. To finish this post I just want to point out that there is actually a bit of a debate in the economic research literature about how good these political processes would really be and what voting system, if any, would be best for such issues, but I will leave it at that.

One thought on “Intro to Econ: Eleventh Lecture – Solutions to Negative Externalities through Taxation

  1. Pingback: Intro to Econ: Eleventh Lecture Aside – Why don’t we have a global carbon tax? | Graz Economics Blog

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