Here’s a quick list of reasons to tax. Each have a bit longer explanation down below.

We tax to…

1. pay for public services that are easier or more efficient to provide as a community than to pay for individually.  (AKA public goods)
2. correct for inequalities in individual wealth or income – to provide some basic level of food, shelter, medial care, etc. (AKA welfare and other social services)
3. correct for externalities.
4. Change behavior – encourage or discourage through incentives

1. Public Services/Public Goods:  There are services that many people want, but individually we could not afford to buy them. While it is possible for groups of individuals to come together privately to pool their funds and provide the service, they often run into the free rider problem. So we give government the ability to build roads, provide police and fire protection, and many other worthwhile goods and services. Often times voters have to approve the tax to pay for these. Here are some other posts on the topic.

2. Income Redistribution / Social Services: In some economies there is an explicit goal for a Robin Hood policy (take from the rich and give to the poor) – purely to even out income or wealth. In the United States and many other countries there is a social ethic or value that says that the poorest members of society should be able to live in at least some minimum level. This ethic or value is controversial, of course. Some voters support strong government efforts to improve the lives of our poorer members – along the lines of European social democracies. Other voters prefer a self-determination, self-reliance model, where citizens have opportunities but are left to their own to survive or advance in the world. And many voters are somewhere in between. In a later post we’ll show how many tax strategies focus on extracting more tax revenue from the wealthy than from the poor.

3. Correcting Externalities: In economics we call the presence of externalities a market failure. When someone outside of a market transaction is either harmed by or benefits from that transaction, we have an externality. If there is an externality then the market will produce either too much or too little of that good, and will not reach a social optimum. The most common example is factory pollution. When the factory produces a good and pollutes while doing that, others outside the factory are affected. See more on externalities here.

4. Incentives to Change Behavior: Some times we enact taxes to discourage behavior. “Sin taxes” are one such example. Tobacco taxes can be used to defray state health care costs. Generally this is a pretty inefficient mechanism since many of the “sins” are addictive and demand for them price inelastic. More often a tax on tobacco or alcohol is just a convenient way to raise revenue, and voters are more likely to support those taxes over more general income or sales taxes. A more modern application of this category is called a Pigovian tax, and the prime example being discussed is a carbon tax. Taxing activities and products that release carbon into the atmosphere should discourage and reduce those activities.  We also give tax credits for behavior we want to encourage.

Here’s an excerpt:

In the years leading up to his death, in 1959, he was a reclusive figure, rarely venturing from his rooms at King’s College. His novel ideas on taxing polluters and making health insurance compulsory were met with indifference: Keynesianism was all the rage.

We’ve talked about Pigou, and his Pigovian taxes in other posts. As the article reminds us Pigou recognized that sometimes market dynamics fail to address social needs. One set of these market failures (or imperfections as they are also called) is externalities. These occur when players that are not a part of a transaction are affected by the transaction. Neighbors living next to a polluting plant do not participate in the sale of the goods or power produced by the plant, yet they incur a cost. The friends of a child who has been immunized benefit from that child’s vaccination, yet they don’t get involved in the cost-benefit decision made by the child’s parents. Both are cases of externalities. A Pigovian tax can help remedy a negative externality, providing incentive to the polluter to change their behavior.

The report mentions an estimate that a 10% rise in cigarette prices results in a 7% drop in smoking among youth and a 4% drop in smoking among adults.

There are a variety of studies on the price elasticity of demand for cigarettes, with varying estimates. The Surgeon General’s office issued a report summarizing the findings from a number of published studies. While the estimates differ some, the difference of elasticity between adults and youth smokers remains significant.

So, let’s review what price elasticity measures. The value of E is the ratio of the percent change in quantity demanded over the percent change in price. For a normal good, E should be negative – i.e. an increase in price yields a drop in quantity demanded, and a decrease in price yields an increase in quantity demanded. In either case one part of the ratio is negative, so the value of E is negative.

The figures reported by NBC (and many of the studies summarized by the Surgeon General’s office) show price elasticity for adults and children to be less than one. More accurately, the absolute value of E is less than 1.0. That means that quantity will change, percentage-wise, less than the change in price. OK – that makes sense. Smoking is understood to be addictive, and so we would expect that smokers might cut down on smoking as prices rise, but not by much.

What, then, is the explanation for youth smokers being “less inelastic”? Perhaps they are less addicted, since their experience with smoking is shorter. They also probably have less disposable income, and so even a modest price rise cuts into their budget more deeply. Are there other explanations?

By the way, the cigarette tax is an excise tax. Given the inelastic demand, we will expect only modest declines in smoking, but the government can expect to generate significant tax revenue.

One charming by-product of this approach is that interested third parties can participate in the permit trading market. They can bid to buy permits, and then remove those permits from circulation.

Here is a small example of this process – reported by the Adirondack Daily Enterprise – published in Saranac Lake, NY.

U.S. Rep. Kirsten Gillibrand said she’s dreaming of a green Christmas.

The recently re-elected Democrat from Greenport permanently retired nine tons of carbon dioxide pollution allowances on Monday evening, for a cost of $75, the first person to do so. She bought three $25 certificates, one for her and one for each of her sons.

“It’s a very special Christmas gift for each of them,” she said.

Sounds like good stocking stuffers.

Here’s a recent example. From the Chicago Tribune on November 14, 2008:

Want to stop people from drinking too much? Forget earnest public service announcements. Just make alcohol more expensive.

A study released Thursday by the American Journal of Public Health found that when the tax rate on alcohol went up, deaths caused by drinking went down.

So, in this case the purchase and consumption of alcohol has a negative externality – a larger number of deaths in society. A higher death rate imposes a social cost – to innocent victims of drunk drivers, to lost productivity, and to related damage. A tax on alcohol is a Pigovian tax. It does not ban the purchase of alcohol, but the higher resulting price provides an incentive to change purchase and consumption behavior. The study mentioned in the article provides a link between the tax and reduced alcohol-related deaths.

The principal challenge in creating a Pigovian tax is estimating what the social costs are, and setting a tax that recovers those costs. And, we know that imposing a tax, particularly an excise tax on something like alcohol, results in deadweight loss – a net loss in combined consumer and producer surplus.

“…come again?…” Here’s what I mean…. Let’s assume that a coal burning electric power plant produces pollution as a by-product of power generation. The pollution imposes costs on the neighbors – impacting quality of life, or health issues, property values, etc. So the pollution represents a negative externality. Instead of using direct government regulation, where laws and regs require certain actions, a different option is to add a tax that matches the external costs being created. If there are $50 million in external costs a tax of $50 million is imposed. Ideally this tax goes up and down with the amount of pollution released. Here’s the Wikipedia write-up.

If done correctly this Pigovian tax will change the behavior of the producer – the electric power plant. They will adjust their output (usually lower) based on the various theories on how producers choose optimum output. The important point is that those external costs are now being considered, rather than ignored.

Two important points about a Pigovian tax. First, there is a direct financial impact on the producer, but they are left with the option on how to minimize the tax. They can choose smoke stack scrubbers, or they can look for a better coal, or they can reduce output. The choice is theirs and in theory they will make a more efficient choice than a standard solution required by the government. The other important point is that funds are collected by the tax and can be used to reimburse those harmed by the pollution.

There is one remaining downside to a Pigovian tax. Like many such taxes, there is deadweight loss, where the combined consumer surplus and producer surplus show a net loss after the imposition of a tax. Here we have to weigh the relative importance of the deadweight loss against the importance of trying to solve the negative externality.

Greg Mankiw (currently teaching at Harvard and previously chair of the President’s Council of Economic Advisors under Bush) is a fan of the Pigou solution and has formed an informal Pigou Club. See this post for a recent example, from a candidate for the U.S. Senate in New Hampshire.

In a nice, idealized market place the buyers and sellers come together at a price point where the private benefits of the purchase to the buyer equal the private gains to the seller. If, very hypothetically, I bought a cigar, and the market was performing well, the price I paid would be less than or equal to the value I place on having the cigar. The seller agrees to this same price, estimating that the price will compensate the seller for direct costs of production and opportunity costs of being in the cigar business.

So, now I own a cigar, and wish to enjoy it. Unless I do it in the middle of the woods, it is likely that someone else will be affected by my smoking the cigar. More often than not that person will be annoyed with my cigar smoking, or even harmed, health-wise. So that person has borne a cost of my cigar purchase. We call those social costs – to distinguish them from the private costs represented by the price I paid. When I bought the cigar I did not include those social costs in my calculation of whether the price was a good deal or not.

If we look at my cigar purchase from a social or community perspective, my failure to take into account the costs borne by others means that the price of the cigar is too low and that I will buy too many of them as a result. The market price in this case establishes an efficient price and quantity, but only measured in private terms. In social terms, price is too low and quantity is too high.

This cigar scenario is an example of a negative externality. A negative externality exists when there are social costs involved in a transaction in addition to any private costs.

On a larger scale industrial pollution is a good example of a negative externality. Left to pure market forces a factory that pollutes doesn’t feel those outside, social costs, and over-produces and over-pollutes.

The typical government response to a negative externality is to regulate it in some way. This can involve direct regulation, such as prohibiting smoking in public places, or requiring a factory to install pollution control equipment. There are some more market-driven examples of government intervention, including the now famous cap and trade approach found in the Kyoto Protocols and other domestic initiatives, and also including Pigovian taxes. The latter seek a way to internalize the outside costs, so that the producer/polluter must explicitly take these costs into account. The difference is that with a Pigovian tax, the polluter is free to do what they wish, and we hope that the financial incentive of the tax nudges them in the right direction.

There are positive externalities as well. These are situations where the buyer only measures their private benefit of a purchase and ignores the benefit of the purchase to others. A classic example of a positive externality is childhood vaccinations. When a family decides whether to vaccinate their child, they compare the benefit to them (increased health for their child, less worry on the part of the parents) against the cost of the vaccination. What they don’t take into consideration is that the playmates of their children also benefit from their own child’s protection. If I vaccinate Max, his playmates are better off, because someone with whom they have frequent contact is now protected and won’t spread the disease to them.

In the case of a positive externality, the family’s decision, based on private benefits and private costs will result in too few vaccinations. If we could recognize the benefits of our choice to our friends and schoolmates, then we would see more vaccinations.

Government can intervene in a market that has positive externalities in a number of different ways. They can issue direct regulations, such as requiring certain childhood vaccinations before the child can attend public school. They can also add market incentives, such as subsidizing the cost of vaccinations.

All this talk of government intervention needs a counter weight. It is possible for people to solve the problem of an externality privately. In the cigar example, there may be social pressure to smoke in seclusion, with nothing more than glares or coughs or suggestions from those bearing the outside costs. Sometimes the private solution can involve money – “I’ll pay you a certain amount of money to keep your cows from eating my vegetables.” And this talk of private solutions can take us down an interesting path – looking at when we act in altruistic ways, with no apparent compensation for our troubles. That’s the subject of a different discussion, at a later time.