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An externality, in economics terms, is a side effect or consequence of an activity that is not reflected in the cost of that activity, and not primarily borne by those directly involved in said activity. Externalities can be caused by either production or consumption of a good or service and can be positive or negative.

Excise Taxes

Taxes aimed at externalities are focused on minimizing negative externalities in particular, or societal costs associated with certain consumption and activities.

For example, drivers of gas-powered vehicles pay the gas tax to account for the externalities related to driving, like pollution and wear and tear to the roads. Levying an excise tax like this one can help ensure that the costs of driving are borne by the actual users of the road, rather than the general taxpayer.  Similarly, excise taxes on gambling, alcohol, and tobacco reduce societal costs generated by those activities.

However, there are several challenges to imposing excise taxes in response to negative externalities:

  • There is usually no way to accurately measure the societal cost or externality.
  • It is difficult to measure the effectiveness of public policies in deterring or reducing externalities.
  • Fully efficient taxes that seek to recover external social costs may vary by location and person; a theoretically correct tax would need to vary according to these differences.

In some cases, the government may subsidize behaviors or activities through the tax code that it believes generate positive externalities. For example, research and development (R&D) by a firm can improve an entire industry and boost the economy, producing larger benefits for society as a whole rather than just the firm. However, as with negative externalities, positive externalities can be difficult to measure and public policy may not always be the most efficient way to generate them.

Examples of Taxes Aimed at Externalities

General tax types that target negative externalities are excise taxes, sin taxes, and Pigouvian taxes. More specific taxes that work to minimize societal costs include cigarette and vapor taxes, beer taxes, soda or sugar taxes, the gas tax, cannabis taxes, and a carbon tax.

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