Earth Day Blog Post: Tax Policy and the Environment

April 22, 2008

Environmental issues have become even more front and center in recent years, and tax policy is in the middle of it all. Any introductory economics student will learn about a concept called externalities, whereby a market transaction between two parties (buyer and sellers) has some spillover effect on a third party that the buyer and seller are not concerned with. Externalities can be either positive or negative. The classic example of a negative externality is pollution. The buyer of steel has no incentive to reduce the pollution of the steel mill that goes into the air, while the steel mill owner has no incentive either. There are two solutions: allocate property rights for the air to some party (which can be transferred via sale) or impose a tax for the right to pollute a given amount of pollutant.

The optimal amount of pollution from a societal well-being perspective in almost all cases is greater than zero, but it is almost always less than the market amount that takes place without regulation or a tax. Even if there is some uncertainty regarding the extent of the harm done by a pollutant (such as the case is with global warming), assuming that there is some probability of some harm existing from the pollution (i.e. greenhouse gas emissions), the optimal tax would be greater than zero (ignoring transaction costs of imposing and enforcing the tax, as well as possible large variances that could exists). Note that this all assumes a benevolent government whose decision is not influenced by special interests, which is where the public choice school of economics questioned Pigouvian taxation.

For more on the issue of externalities and environmental taxation, the following is a list of some of the major papers on the topic in the economic literature, including the two classics from Pigou and Coase, which are highly recommended for those new to this issue.

Pigouvian Taxation

First, an overview of Pigouvian taxation via Wikipedia.

The Economics of Welfare by Pigou. Full text available via

Baumol, William J, 1972. “On Taxation and the Control of Externalities,” American Economic Review, American Economic Association, vol. 62(3), pages 307-22, June.

Read more about Pigouvian taxation from its present-day staunchest defender, N. Gregory Mankiw.

Coase Theorem

Coase, Ronald. “The Problem of Social Cost” in Journal of Law and Economics, v. 3, no. 1 pp. 1-44, 1960. Available here:

Environmental Taxation

For a list of papers on energy economics and environmental taxation, check out this page from one of the issue’s most influential researchers: Gilbert Metcalf of Tufts University. Recommended highly is his overview of federal tax policy towards energy and his two working papers from 2007 on carbon taxes and cap-and-trade.

Another influential researcher in the field of environmental economics is Yale University’s William Nordhaus who has developed an economic model of climate change.

Kevin Hassett’s and Gilbert Metcalf’s review of what would be good federal tax policy towards energy.

Here’s a website for an AEI event held last year on the topic of energy taxation, including video.

Minneapolis Fed piece entitled “Putting a Price on Carbon” (nice easy-to-read overview of issue of cap and trade versus carbon tax)

The Economics of Climate Change: A Primer, CBO paper

Policy Options for Reducing CO2 Emissions, CBO paper

Questioning of Pigouvian Taxation

Previous Tax Foundation blog post discussing the extent of Pigouvian taxation

Criticism of Pigouvian taxation from Mises Institute

Other Tax Foundation posts on Pigouvian environmental taxes are available here, here, here, here, here, and here.

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