November 20, 2008
An “externality” is an external cost (or benefit, for that matter) that is imposed on a third party that is not directly involved in an economic transaction. Externalities represent a form of “market failure,” i.e., because there are these external costs, costs are not accurately reflected in the price in the transaction. This leads to sub-optimal outcomes.
The use of oil is a perfect example of the externality problem. There are a large number of external costs imposed on third parties with the use of oil. Burning oil (say, by using gasoline as fuel or oil to heat a home) pollutes. It also releases greenhouse gases that contribute to global climate change. These costs are not reflected in gas prices. Likewise, the use of automobiles imposes costs on third parties. Among other things, cars pollute (not just from burning gasoline), cause wear and tear to infrastructure such as roads, create traffic, and pose safety risks. These costs are not all accrued to the users of the cars but are also imposed on third parties. For example, if you live near I-93 north of Boston (or any other major urban highway), odds are you are paying costs in terms of health risks. Asthma rates in neighborhoods near these highways are higher (especially among children) and lung cancer rates are higher as well, largely because of particulate matter caused by heavy traffic. These costs are paid by neighborhood residents (and not the commuters on those roads) even if they don’t use those roads or drive a car.
Let me give one more example to make this particularly clear. Let’s say that I live next door to you, and I decide to open up a restaurant in my home (which, if you’re a true-blue Republican or Libertarian, you should support as a matter of individual freedom and laissez-faire capitalism). If I were to open such a restaurant – let’s say it’s a seafood restaurant – there are going to be a number of externalities involved that impose costs on you. First, patrons are going to show up (I would hope – I’m not that bad a cook!), and they’re going to cause noise and parking problems. Second, I’m going to be cooking and throwing away a lot of fish (and other sorts of garbage), which isn’t going to smell all that pleasant even from your side of the white picket fence. Not all of the externalities are costs – you don’t have to walk that far to get delicious fish meals, for example. But for the most part, at least in this case, there are a number of unpleasant costs that are imposed on you without your permission.
There are a number of different ways to address these externality costs, and most of which involve government intervention (anathema to the far right). In the seafood case, government usually imposes zoning restrictions – in most locations you can’t open up a fish restaurant in the middle of a residential neighborhood. There are also zoning laws that take parking and noise into account, require the building of parking lots, require certain types of trash receptacles to prevent bad odors, require the removal of garbage at certain intervals, etc., etc. These regulations are aimed at shifting externality costs from you, the neighbor, to me, the seafood guy. Instead of you paying by suffering noise and smell, I have to pay by paying higher rents in the commercial district, building a parking lot, etc. And the government is imposing those costs on me in the form of regulations.
It is similar in the gasoline/car examples, but they are more complex. Burning gasoline imposes health costs, for example, but instead of those health costs being imposed on a single neighbor, they are spread widely across society. We all suffer higher rates of asthma, lung cancer, etc., and we all will suffer from climate change. In order, then, to shift costs from us to those actually burning the gasoline, the government steps in. They can do so, as they did in the seafood case, through regulations. For example, we have fuel efficiency regulations on automobiles in the United States (weakly, for sure, but we have them). But one of the more efficient (and egalitarian) ways of shifting externality costs in this case is through the use of taxation. Government can impose a tax on those who burn oil or use the roads (gas taxes, road and tunnel tolls, excise taxes on cars, etc.). They can also charge fees (require auto registration and charge a fee for that service). This accomplishes several things: by raising the cost of driving and using gasoline, it can reduce those behaviors to a level that better reflects their actual costs in health and climate change; it also creates a revenue stream that can be used to build and repair roads, build walls to insulate neighborhoods from traffic noise, etc.; finally, it can be used to provide things like health insurance to those who suffer higher rates of asthma and other diseases, to provide public transportation, etc.
In practice, however, it doesn’t quite work this way. Gasoline taxes in the United States are set far below optimum levels. As a result, gas in the US is relatively very cheap (take a look at Canada and Europe), and there is a greater incentive to drive more than is optimal and to drive large vehicles with worse gas mileage than is optimal. Also, the revenue streams from the taxes that do exist are not properly earmarked for layouts that offset the costs of car use. The gas tax should properly be earmarked for use in maintaining infrastructure and building public transport. In reality, that’s not the case. As a result, there is rampant underprovision of these goods – we maintain our roads and develop our public transport at a level far below what is optimal in the US (and far below what is done in places such as Europe or Japan).
Now, to be certain, NOBODY likes paying taxes, and NOBODY wants to pay more for cars or gasoline. But the truth is that the costs discussed above ARE REAL, NOT IMAGINARY. They are no less real when they are accruing to a third party, just as the costs imposed on you by my seafood restaurant next door would be quite real. The government is, by levying taxes and tolls, merely shifting those costs that (UNJUSTLY!) are accruing to third parties back where they belong – on the car users themselves.
And, importantly, this isn’t just about equality and justice and good cuddly things like that (listen up, Republicans!). It is also about ECONOMIC EFFICIENCY. The market (at whose altar the right worships) can only function properly when prices are set rationally. The price of gasoline cannot be set rationally when many of the costs of using it are imposed on nameless, faceless third parties.
So after all that, now I come to Massachusetts. Massachusetts has a particular problem when it comes to the gas tax. It’s almost a perfect storm. There is the perception in this state that taxes are too high, not too low. Likewise, there is a perception that Massachusetts’s taxes are higher than everywhere else (can you hear the Republicans shouting “Taxachusetts?”). In fact, the gas tax in this state is 24 cents/gallon, which puts Mass. in the bottom half of states. By comparison, California charges 46 cents/gallon, Connecticut 44 cents/gallon, and NY 41 cents/gallon, so almost twice what Mass. charges. Also, Mass. hasn’t touched the gas tax since 1991, meaning that while gasoline itself has increased in price, and while gas usage has gone up, and, indeed, even while the purchaing power of 24 cents has gone down, the tax has remained exactly the same. So in terms of real dollars (i.e., adjusting for inflation), the gas tax has DROPPED quite a bit over the past 17 years (a big reason why the tax should be indexed for inflation – good luck getting that passed).
There is also a profoundly anti-tax sentiment in the United States and some confusion over its purpose (and legitimacy). There is awe-inspiring resistance to taxation in this country, and a widespread perception that taxes such as the gas tax are nothing more than punitive and arbitrary ways for the government to procure funds for (largely wasteful and unfair) welfare programs (or handouts to corrupt officials). These beliefs make it politically very difficult to adjust taxes on gasoline to optimal rates (and go a long way toward explaining why tax rates on gasoline are much lower here than in other similar countries).
Finally, the truth is that Massachusetts should rank toward the top, not the middle, of states when it comes to taxes on gasoline. Massachusetts is an urban and VERY densely populated state, with most commutes being concentrated around one large metropolitan area and a few major highways. On top of this, the roads and public transport are in particularly bad repair compared to other states (or countries), AND Massachusetts continues to owe an enormous (perhaps crippling) debt resulting from a single gigantic road project in downtown Boston (the Big Dig, of course).
Mass.’s governor has recently proposed increasing tolls on a handful of roads and tunnels around Boston to record levels (in some casing doubling tolls) in order to address Big Dig debt and other transportation funding shortfalls. This is likely a political ploy to put pressure on the legislature to pass a far more equitable gas-tax increase (the toll increases, obviously, would be paid by only a small subset of the state’s drivers, while a gas tax would accrue to all drivers, AND it would accrue more greatly to those who drive vehicles with lower fuel efficiency). In fact, the (less than always admirable) Speaker of the House Sal DiMasi has recently reversed his position on the tax and has come out in support of them, largely as a result of the threatened toll increases.
These taxes need to go through. First, the current budget shortfalls need to be met one way or another, and this is a more equitable way of doing that (the right will, of course, shout “spending cuts,” which could not even begin to address the necessary servicing of outstanding debt – how large to they think discretionary spending is to begin with?). Second, as climate change becomes a greater and greater issue (and it is essentially a critical issue now) gas prices are going to have to come closer to reflecting actual costs. They’ll never come all the way, not in this political climate and not while Massachusetts has to compete with other states, but some is better than none.
It would be good to see AT LEAST a 15 cents/gallon increase in the tax. It would be even better to see the tax indexed for inflation so we don’t have to refight this issue in the legislature every few years. And it would be even better if we could set some provisions for diverting some of the revenues from these taxes permanently toward public transit projects.
Other than that, we can certainly hope that when the new presidential administration comes in, they will reverse the EPA’s ruling on California’s fuel-efficiency standards so we can finally raise them. That should also be a sine qua non for any bailout package for Detroit.
OK, so there’s a VERY long disposition on the gas tax. Maybe I’m being a windbag here, but this is an important issue (and, by the way, I didn’t even mention the security externalities involved – we import most of our oil! – but that’s for another time).
Also, here’s a link to a scholarly paper by Ian Parry and Kenneth Small on gasoline tax optimization. It’s a start if you want to read something serious on this (as opposed to the pompous pseudo-intellectual stuff I wrote!).