The power of Pigovian taxes

Tax reform could result in improved energy use and consumer responsibility.

by Derek Olson

If you’ve filled up at the pump recently, you probably were reminded how much it costs  to drive. But all the gas, insurance, repairs and other things you pay for are not the only costs of driving. Your contribution to traffic congestion places cost on other drivers, your wear and tear on the roads puts cost on taxpayers, and cost is born by the environment due to the pollution from your car.

These are three of the many examples of the external costs of driving, or what economists call negative externalities. It was first recommended in 1920 by Arthur Pigou, an economist from the University of Cambridge, that negative externalities be taxed to internalize the costs. Pigovian taxes are a way of making individuals themselves pay for the costs they place on others. This eponymous form of taxation is now supported by economists as diverse as Paul Krugman and Alan Greenspan. Conservative and liberal economists alike widely favor Pigovian taxes, especially on carbon emissions and gasoline. We just need our politicians to follow their economic advisors.

President Barack Obama recently announced mandates for dramatic increases in the Corporate Average Fuel Economy standards, but this is economically harmful. A 2007 study published in Economic Inquiry found that an 11 cent increase in the gas tax would conserve the same amount of fuel as a 3.0 mpg increase in the CAFE standards. More importantly, it found that the increase in CAFE standards would have a welfare cost 14 times greater than the tax increase. Many other studies have corroborated the finding that paradoxically, gasoline taxes are the less expensive way to conserve fuel.

The problem with fuel efficiency standards is that they do not change consumer preferences. Consumers will have little, if any, new incentive to be fuel efficient. The new standards force automakers to manufacture vehicles that the market is not demanding, which increases the price on new vehicles. With higher prices on new cars, consumers will shift to buy used cars, and this won’t accomplish any fuel reduction because used cars are not affected by increasing fuel standards.

Energy policy needs to affect consumer behavior in order to reduce the usage of energy. When the price of gasoline rises, drivers get creative. They carpool, use mass transportation, buy a more fuel-efficient vehicle, walk or bike and even move closer to work. Numerous studies and extensive empirical data show strong correlation between gas price and consumption per capita in developed countries. Consider how often gas prices are on the news. One can think of few other things for which people watch the price so closely.

If gasoline prices were higher, consumers would find it financially rational to buy a fuel-efficient car, and they wouldn’t do it solely by the good graces of their sympathy for the environment. The American Ford Fiesta gets 33 miles per gallon fuel economy. However, in the UK, where gasoline taxes are approximately $4 per gallon, Ford produces a version of the Fiesta that gets nearly 72 miles to the gallon. The government is distorting the market with CAFE standards, forcing auto manufacturers to sell products people aren’t demanding, the result of which is higher prices on all vehicles. Higher gasoline taxes are a less invasive way to alter market demand by making it a financially beneficial decision to buy a fuel-efficient car. If consumers actually want more fuel-efficient cars, as they would with higher gas prices, CAFE standards become altogether futile.

America’s problem with the rest of the energy crisis is similar. The debate rages over how to force the economy to use “green” types of energy sources, and the response is often subsidies. Because every major form of energy production is subsidized in the US — oil, coal, gas, nuclear, wind and more — the net result is all energy is less expensive. Just as with gasoline, people consume much more energy with lower prices. While there is much discourse about energy independence and its national security implications, the government is aiding and abetting the problem by promoting the use of energy.

If energy were more expensive, people would have a greater incentive to use it sparingly. Businesses would make their products more energy efficient for consumers who are watching their utility bills. It would be more profitable to research and invest in innovation for energy efficiency and conservation. Yet, we are making energy less expensive and consequentially decreasing private investment in innovative energy technology.

If you tax something, you get less of it. This economic phenomenon should teach a simple lesson: We should focus on taxing things that are bad for society not things that are good for society. Our current tax system focuses largely on taxing income, which is something society wants. Pigovian taxation would be even more powerful in increasing market efficiency and bipartisan in agreement if it coincided with decreased taxes on things that are good for society, such as

Just as a large majority of economists proudly support higher gasoline taxes, I believe that a majority of politicians would too, if it weren’t for the public affixation to measure their performance by the price at the pump. The next time there’s a spike in the price of gas, there’s sure to be a lot of pessimism in the media, but economists everywhere will be smiling.