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Friday, April 27, 2007

My response to Karl Smith

Karl Smith writes:

"A few people have complained in the comments on Greg's site that we shouldn't increase the gas tax because we don't know the elasticity of gas or how much consumption we should give up in exchange for saving the envrionment.

There are two points about this. First, we do have estimates of the price elasticity of gas.Secondly, however, the beauty of Pigouvian taxes, unlike cap-and-trade by the way, is that we don't have to know that much. We don't need to know elasticities. We don't need to know the "right" amount of pollution. We don't even need to know whether or not people should be driving less.We do have to an estimate of the envrionmental damages that gasoline brings. Admittedly that might be hard to pin down exactly. The nice thing about taxes, however, is that if we are off by a bit the economic harm isn't that great.See the price of gasoline is basically the cost of making it plus some reasonable profit for the refinery. There is the messy issue of OPEC but that has become increasingly less important in recent years.

So when people decide to fill up their tank they are implicitly asking themselves, "Is the benefit to me of taking this drive greater than the cost to the driller of drilling the well, plus the tanking company for transporting the crude oil, plus the refinery for turning it into gasoline plus the retailer for operating this store plus the tax the state charges for building the roads." If it is then the motorist fills up her tank content in the knowledge that she has maximized social welfare. She imposed a cost on all of those people, but the benefit to her was greater and she proved it by paying the going price for gasoline.

But wait! We forgot someone. We forgot the child who will be born just one day to late ever see a glacier because our motorist added just a little bit more carbon to the atmosphere and speed up the rate of global warming by a teeny-tiny amount.The little child did not get paid and so our motorist can no longer be confident that she is maximizing social welfare. We can she do!? Should she shun gasoline forever? Feel guilty until the day she dies?Well, she could just pay him. The one problem is that since our kid isn't born yet we don't know exactly what his asking price will be. We have to take a guess.

But, once we make that guess we add it to the price of gasoline and our motorist is once again happy in the knowledge that she has made the world a better place.In this entire story we didn't say how much gasoline our motorist was buying, where she was going or even what kind of vehicle she's driving. Thats because we don't really need to know. All we need to know is that she was willing to compensate that little boy for the cost she was imposing upon him."

My reply:

You said,"we do have estimates of the price elasticity of gas."Which is true...the problem is they vary from an insignificant amount (-.0X to about -.5 or so). The lateset paper I read, using recent data, has elasticity so miniscule (-.04 in the short run and not much better in the long run) as to make any gas tax policy either farily worthless, or politically ridiculous....The notion that elasticities aren't important in determining the gas tax is flawed:You can determine the cost of the externalities beyond the private cost - true. And yes, we may even be able to pinpoint a value. And from that value, we may be able to set a gas tax to compensate the future loser.

And all that would be fine IF the gas tax were to go to the future losers as compensation.But it doesn't. There are two options to compensate the losers:
-put the revenue from the tax directly into bettering the environmentor
-put the revenue in a trust fund to provide future generations as an outlay

Either way you do the compensation, the current users suffer via higher (regressive) taxation. The whole notion of :"But, once we make that guess we add it to the price of gasoline and our motorist is once again happy in the knowledge that she has made the world a better place." wrong. They are not "happy."

If they were happy to pay the higher price, you would not have had to tax them in the first place!!!

That leaves us with two problems: how can we compensate both the losers in the present (due to higher taxes) and the losers in the future (environment). We do this by taking the revenue from the tax hike to repay the current losers, and we ASSUME the elasticities are such that carbon consumption falls by enough to provide the adequate benefit to the future. So you see, the assumption of elasticity IS important if you intend to compensate the current losers (as Mankiw would want to do)

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