Friday, April 22, 2011

Protect Mother Earth with ... Taxes?

It's Earth Day TM so what better day to talk about externalities?

Externalities in economic terms are costs or benefits that reside outside the direct costs or benefits of a transaction between two parties. In other words, an externality is not reflected in the transaction price.

There are positive externalities and negative externalities.

Positive externalities provide a spillover of benefit to a community.  For example, if you pay a landscaper to beautify your front yard, your neighbors may see an increase in property values despite not having been a party to the transaction between you and your landscaper.

Negative externalities provide a spillover of harm or cost to a community. For example, tobacco use can lead to 2nd hand smoke and uncovered medical expenses absorbed by a community.

One way economists have advocated for accounting for these externalities is through the tax code. Taxes on alcohol and tobacco are higher, because of the negative externalities associated with these purchases. These kinds of taxes for negative externalities are often criticized by opponents as being a sign of the pervasiveness of "The Nanny State" - an over-controlling government intent on dictating the behavior of its citizens. When, in fact, it is an appropriate method for trying to ensure that the transaction costs reflect the true costs.

Conversely, tax credits are offered on hybrid cars, because they reduce energy use and pollution. Funny how these kinds of incentives don't receive nearly as much criticism even though it alters the transaction costs and reduces tax revenue (increasing the deficit). It is still a "Nanny State" at work, but to the benefit of the consumer.

How is this related to Earth Day TM ?

Well, arguably the biggest negative externalities are associated with the environmental pollution that results from transactions - consumption of goods and services:
  • Pollutants from burning fossil fuels. 
  • Chemicals spilled into our waterways.
  • Waste materials from manufacturing.
  • Disposal of replaced items (e.g., old computers, cell phones)
  • Air quality from traffic congestion.
All of these and many others represent negative externalities that can be mitigated through environmental regulation or changes to the tax code.

This is where the idea of Cap & Trade legislation comes into play.  A government sets a cap on how much of a pollutant may be released into the atmosphere and companies would bid for credits under this cap. Revenue from this auction would go toward government revenue. A company who wants to pollute more than they have credits for can buy (or trade) for credits from a company that is not using all of its credits. This is a market based solution to pollution control, and yet there is resistance to this kind of approach. There are a fair number of arguments both from the extreme right and extreme left when it comes to this proposed solution.The left doesn't think it will have a serious effect on pollution (i.e., governments will set the caps too high to make a difference) while the right thinks it's an unnecessary imposition on business transaction costs.

Yep, you got that right. "Free market" advocates argue against a Cap & Trade solution, because it requires purchasers to pay for the full costs of the product they buy.  So much for an efficient market - one where prices reflect true value.

So enjoy your Earth Day TM and please do something for the environment that you normally wouldn't. Me? I'm working in the dark.

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