One of President elect Obama’s many campaign promises(1) is to Provide Meaningful, Permanent Tax Relief for Middle Class Families.  Another one is to Invest In A Clean Energy Economy and Create 5 Million New Green Jobs. And still another one is to Reduce Dependence on Foreign Oil, and also to Tackle Climate Change.

A tall order for any president, if it wasn’t for the existence of about a hundred other claims on future governing and policies.

I think Mr. Pigou could actually and realistically help Mr. Obama reach the above goals, if only he’d listen, and if only Pigou was still alive.

The basic question from environmental economics is : should government intervene and address the social and environmental issues caused by market failures and the socially undesirable effects of externalities?

Mr Obama says yes.

The early work of greatest significance arguing for government intervention was British economist Arthur Pigou (1877-1959).

In his The Economcs of Welfare (1938), Pigou(2) was among the first to acknowledge the existence of externalities and the associated divergence between private cost and social cost. He argued that the societal problem of externalities cannot be solved by contractual negotiation, as proposed by Coase(3). He went on to propose direct government intervention or judicious uses of taxes against the offending activities. Taxes based on externalities are often Pigouvian taxes, and the process of finding the correct measures to take effect is often called internalising the externality.

It is important to note that Pigou did not suggest taxing goods and services which have an externality but the externality itself, e.g. carbon in the air, nitrates in the water, etc. For example, when coal power plants emit traces of mercury, we should not tax the power produced, but the harmful mercury emitted. The electrical power is a valuable commodity, a good, but mercury accumulates in nature, poisons ecosystems, and through the food chain affects infants’ cognitive, neurological, cardiovascular, immune and reproductive systems(4).

It is the externality that creates the extra social cost, so it is the externality that should be taxed. The thinking is that maybe the tax would represent enough of an incentive for the power plant operator to e.g. switch fuel type, or look for technological solutions to capture the mercury before being emitted, thus lowering his tax burden and raising his profits.

Tax bad things, not goods, Pigouvian taxes

A practical example of a Pigouvian attempt(5):

Pushed by an economic growth based on agro-exports and cattle-raising, Costa Rica’s dense forest cover was reduced to 64% by the 1950’s. In the following 40 years, it decreased to less than 25%. Major steps were taken during 1969-1986 to create state protected areas nationwide. This conservation system covers today over 25% of the national territory and it contains 3-4% of global biological diversity.

However, one of the most important innovations of Costa Rica's 1996 Forestry Law was the decision to compensate forest owners for the environmental services their forests provide to society. This system, the Payment for Environmental Services, is supported by a tax on fossil fuels. Several studies have shown that Costa Ricans are willing to pay for these costs in order to maintain the ecological functions and environmental services derived from forest ecosystems, particularly mountain forests. In 1997, US$14 million was paid out for environmental services, which resulted in the reforestation of 6,500ha, the sustainable management of 10,000ha of natural forests, and the preservation of 79,000ha of private natural forests. Eighty percent of this funding originated nationally; the other twenty per cent was generated by the international sale of carbon fixation services under the Kyoto Protocol Clean Development Mechanism. The payment levels established for 2007(6) are US$64/hectare/yr. for forest conservation under a 10 year contract, and US$816 /hectare (disbursed in five years) for new plantations under a 10 year contract.

Basically, Pigouvian taxes would tax the things we do not want in our society, like toxins and greenhouse gases, and NOT tax things we like in society, like employment and housing.

It is important to understand that such Pigouvian taxes are supposed to be a zero-sum exercise, NO new tax income should be generated for government.
Tax revenues raised by e.g. internalizing carbon should be offset by a similar size tax cut on e.g. income from work. And it’s thus that we establish a direct link between employment and a sustainable economy.

The Liberal Democrats in the UK have been the first (I know of) to bring this concept on the forefront of political debate.

Liberal Democrats, UK, 2007

Slowly, many governments are talking Pigouvian, but none are walking it so far. Will the US be the first?

How would this affect American households and tax payers?

According to US IRS data (for 2004), the average American taxpayer reported an income of $51,100 and paid income taxes of $9,377 or 18% of income.

The average American uses 500 gallons of gasoline every year(7). The average vehicle is driven more than 12,000 miles per year today, emitting about 4.7 tons of carbon dioxide(8), depending on the vehicle model and fuel efficiency.

Let’s compute:

This means a carbon tax on transport fuel for cars of $2 per gallon, combined with a tax break of $1000 would result in a zero-sum for the average American.

Are you an above-average fuel consumer, do you drive far for fun, or do you have a long commute to/fro work? Shape-up, get a bike, move closer to work.
Are you a below-average carbon user? Good for you! Use the extra cash to party, enjoy life, and spare a thought for your carbon-heavy-users friends (buy them a bike).