The Case For Environmental Taxes

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

July 21, 2005

Imagine a set of policies that made taxes simpler, fairer and more conducive to economic prosperity. Imagine that these changes also significantly reduced the budget deficit. On top of that, suppose they would lead to a cleaner and healthier environment and might even make for better U.S. foreign policy, too. Fantasy?

No. Let me introduce you to environmental taxes.

It would be foolish to ignore a set of options with all of these benefits, but that is exactly what policy makers are doing. Currently, tax laws not only miss huge opportunities to clean up the environment, they also actively lead to worse environmental outcomes.

The first step should be to remove subsidies that damage the environment. Federal rules provide enormous tax preferences for oil, mining, timber and sport utility vehicles, among others. These subsidies create incentives for overproduction of these goods and they stifle incentives for development of better or cleaner technologies.

Even the mortgage interest deduction is at fault. It may encourage people to build larger primary residences. As Steve Ellis of Taxpayers for Common Sense points out, the deduction also applies to second homes. many of which are built in environmentally sensitive areas. A thorough cleaning of the tax code with an eye toward environmentally damaging subsidies could generate billions of dollars per year in added revenue.

But we can be more ambitious than that. When people or firms create pollution, they are imposing costs on others. It is well-established economics that those agents should pay the full costs of their activities. One way to do this is to require polluters to pay taxes on their emissions.

Craig Hanson of the World Resources Institute notes that pollution taxes can be more effective and flexible than many forms of regulation because they give firms incentives to improve efficiency and environmental quality and allow firms to make cost-effective emission reductions where it makes economic sense — or to pay the tax if not. Pollution taxes also stimulate continuous technological innovation for better pollution control methods.

A broad tax on the carbon content of fossil fuels, for example, would make those who produce or consume products that contribute to global warming face the full costs of their actions and give them incentives to reduce those costs. The tax could also raise substantial revenue. The money raised could be used for some combination of simplifying and reducing other taxes, paying down the deficit and financing appropriate spending. An important benefit would be a reduction in dependence on foreign oil — and the political problems that creates — by encouraging the development of cleaner technologies at home.

A number of common objections to environmental taxes can be addressed. Aren’t all taxes bad? In a poll undertaken by three prestigious academic researchers — Stanford University’s Victor Fuchs, Princeton’s Alan Krueger and Massachusetts Institute of Technology’s James Poterba — higher gasoline taxes were supported by a majority of economists. Likewise, Gregory Mankiw, former chair of the Council of Economic Advisers in the Bush administration, advocated higher gasoline taxes before he entered government.

Would green taxes be disruptive? A carbon tax that raised $40 billion per year would raise gasoline prices by less than a dime per gallon. Would they hurt U.S. competitiveness? As Tufts University professor Gilbert Metcalf has emphasized, the U.S. levies much lower green taxes than other industrial nations, so we could raise such taxes without putting our firms at undue disadvantage. Environmental taxes can be regressive, but they can be combined with other tax changes to make the net effect more progressive.

The president’s tax reform panel is looking for a revenue-neutral tax package. This means that if the panel proposes tax cuts for some purposes, it will need to consider new sources of revenue, such as environmental taxes.

An environmental tax that went partly to simply existing taxes, partly to deficit reduction and partly to finance new spending would be good policy for taxes, the budget and the environment. These days, we do not have the luxury of passing up such viable options.