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[Noah Smith] Taxing bad things isn't always good

The idea of taxing things that are bad for society has a powerful allure. It offers the possibility of a double benefit -- discouraging harmful activities, while also providing the government with revenue.

Take sin taxes. Taxes on alcohol make it more expensive to get drunk, which reduces binge drinking and impaired driving. At the same time, they provide state and local governments with billions of dollars of revenue. Tobacco taxes, which generate more than twice as much, have proven instrumental in the decline of smoking, which has saved millions of lives.

Taxes can also be an important tool for environmental protection, and many economists say taxing carbon would be the best way to reduce greenhouse gas emissions. Economic theory says that unlike income or sales taxes, carbon taxes can actually increase economic efficiency; because companies that pump carbon dioxide into the sky don’t pay the costs of the climate change they cause, carbon taxes would restore the proper incentives to the market.

In reality, carbon taxes alone won’t be enough to halt global warming, but they would be a useful part of any climate plan. What’s more, the revenue from this tax, which would probably be hundreds of billions of dollars per year, could be handed out to citizens as a dividend or used to fund green infrastructure projects.

Then there are those who want to use taxes to discourage excessive trading in financial markets, while extracting revenue from Wall Street. Economic theory suggests that much of the frantic trading that characterizes modern financial markets could be a waste of resources -- traders trying to beat each other to the punch by milliseconds, but not ultimately helping companies to invest more efficiently or helping investors to allocate risk. Leaders such as presidential candidate Sen. Bernie Sanders have proposed a tax on financial transactions in order to curb such excessive trading. Sanders has also promised to use the revenue from the tax to pay for free college and student debt cancellation.

Similarly, a wealth tax has been put forward as a way to reduce inequality while raising revenue. Sanders, like Sen. Elizabeth Warren, has proposed taxing large fortunes at very high rates -- up to 8 percent of total wealth per year for people with over $10 billion, in Sanders’s plan. The revenue from this tax, which Sanders predicts will be over $4 trillion per decade, would be earmarked for housing, child care, health care and other government benefits. If you believe, as many do, that wealth inequality is inherently bad, then these taxes improve society while also swelling government coffers.

But here’s the thing: These sorts of taxes -- which economists call Pigouvian taxes, after the British economist Arthur Pigou -- involve an inherent trade-off. Raising taxes on alcohol or financial transactions above a certain point will discourage the thing being taxed so much that it actually reduces the amount of revenue raised. At that point, legislators have to decide what the ultimate goal is: deterring behavior or bringing in more funds.

In the case of financial transactions, even a modest tax can cause trading volumes to fall substantially, especially for derivatives. Sweden taxed stock trading at a 0.5 percent rate in the 1980s -- the same rate Sanders proposes. But the tax raised only a small percent of the expected revenue, partly because of a dramatic decrease in trading of assets such as bond derivatives. France, Germany, Japan, Australia, Italy, the Netherlands, Portugal and Sweden have all eliminated or reduced their financial transaction taxes in recent years, thanks to disappointing revenue numbers. The UK’s tax has raised more revenue, but still not close to what Sanders projects. Only a few small international financial hubs like Switzerland have managed anything close to those numbers. So a financial transactions tax might eliminate a lot of wasted effort in the finance industry, but it’s unlikely to be a big revenue source.

Very high wealth taxes also have the potential to kill the proverbial goose, or at least shrink it substantially. A 2015 study of Swedish households found that the wealthiest 0.01 percent earned less than a 5 percent annualized pretax excess return on their wealth between 2000 and 2007. In an environment of permanently low interest rates, that suggests that Sanders’s wealth tax -- which is 5 percent for fortunes of $1 billion to $2.5 billion and even higher for bigger fortunes -- would shrink billionaires’ wealth steadily over time, even before accounting for the devastating effect it would have on stock and real-estate values. That’s good news if you believe, as Sanders does, that billion-dollar fortunes shouldn’t exist. But it means that high revenues in the early years of a wealth tax probably couldn’t be sustained over the long term.

The biggest downside of Pigouvian taxation, however, might be political. Governments could become dependent on the continued existence of the things that the taxes were designed to discourage.

Consider carbon taxes. In order to prevent catastrophic climate change, the world needs to eliminate carbon emissions, not just curb them somewhat. This will require switching entirely to carbon-free energy sources and industrial processes. But if governments are dependent on carbon taxes for a substantial fraction of their yearly tax revenue, making this switch would result in either big deficits or severe spending cuts. This could make governments very wary about full decarbonization.

Thus, taxing bad things has its drawbacks. The inherent trade-off between discouraging something and making money off of it, as well as the danger of becoming fiscally dependent on the continued existence of social ills, means that Pigouvian taxes aren’t quite the perfect policy that their proponents imagine.


By Noah Smith
Noah Smith is a Bloomberg Opinion columnist. -- Ed.

(Bloomberg)
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