Taxing Bads

Craig Hanson

June 30, 2005

Craig Hanson is a senior associate in the sustainable enterprise program at the World Resources Institute  in Washington, D.C.

Inside the Beltway, uttering the words "tax" or "the environment" is likely to bring nearly any policy conversation to a screeching halt. However, when these two concepts are put together, the result is an idea that even the most jaded Capitol Hill insiders may find intriguing. Environmental taxes can discourage what we want less of—namely pollution and waste—in order to improve the fiscal and environmental health of our nation.

Economists have praised the notion of "taxing bads" ever since Arthur C. Pigou introduced the concept in the early 1900s. Nonetheless, environmental taxes are virtually non-existent in the current tax code of the United States. This absence is not due to lack of trying, as those left scarred from the Clinton-era battle over a Btu tax can attest. Moreover, there is reason to be skeptical that environmental taxes will be implemented by the Bush administration or a Republican-controlled Congress.

Yet this idea's time has come. Two important windows of opportunity are currently open: the Bush administration's recent calls for revenue-neutral federal tax reform and the country's chronic budget deficit. In both situations, policymakers will have to make difficult tradeoffs and will be looking for new revenue measures. So why not consider fiscal policies that provide revenue and at the same time increase efficiency, stimulate technological innovation, protect human health and improve environmental quality?

One action that policymakers could take to meet tax reform or deficit-reduction goals is to eliminate a number of existing tax exemptions, deductions and loopholes that are both fiscally and environmentally damaging. Most notable among these are provisions for mature industries such as oil, mining, timber and automobiles. Not only do these government handouts to corporations work against common-sense notions of free markets, innovation and fiscal responsibility, but they also encourage mounting environmental and health costs that society must bear. And if that's not enough, the American public is paying for all of this to the tune of billions of dollars a year.

Another way to reform the tax code is to introduce pollution charges on the amount of pollution that a firm or product releases into the air, water, or soil. A pollution tax would be a means of tackling "market failures" that arise when businesses and consumers are not confronted with the full health and environmental costs associated with their activities. Quite fairly, they make polluters pay for their damages and incorporate these costs into their decisions and product prices.

Pollution charges would not even involve a reinvention of the wheel; they are being used in many developed countries and several U.S. states. Even China is using charges to address some of its environmental problems, including water pollution.

There is no doubt that introducing new pollution charges in the United States would be a challenge in today's political climate. That is why initiatives to reform the tax code and to reduce budget deficits actually provide a timely opportunity for instituting such charges.

Consider tax reform for a moment. Revenue from pollution charges could be utilized to lower other distortionary taxes as part of an innovative, revenue-neutral tax reform initiative. For instance, they could be integrated into a fiscal package that lowers payroll or marginal income tax rates. Alternatively, a carefully crafted carbon levy could be used to offset foregone revenue from options under consideration by the President's Advisory Panel on Tax Reform.

This essentially entails a "tax shift." We reduce taxes on things we want more of—such as work and savings—and compensate by increasing taxes on things we want less of—pollution and waste. A tax shift could help mitigate the impact of pollution charges on low-income households or affected businesses.

Furthermore, we could go beyond revenue neutrality and use the proceeds from pollution charges to contribute to such as social and national security. It would also help us avoid passing the burden of higher taxes onto our federal deficit reduction. This would help ensure that the government meets commitments to important policy goals children.

As Alan Greenspan and others have recently noted, new revenue measures will need to be part of an eventual deficit-reduction package. Although these measures alone will not solve the deficit crisis, pollution charges could be an attractive part of the solution.

At the end of September, the President's Advisory Panel on Tax Reform will announce its recommendations. These recommendations will mark the beginning of heated debate in the halls of Congress and in the media over tax reform. Now is the time to begin educating lawmakers and the public about the benefits of environmental tax reform. With the nation's fiscal and environmental woes, policymakers need all the good ideas they can get.