Whew! Gas prices are back down nationwide, to levels not seen in years. Most people are rejoicing, since the last thing they feel they need in uncertain times is to be sending their hard-earned money to oil companies who are already producing record profits.  

But the fact is, we probably weren’t paying enough for gasoline even at its highest levels, because we weren’t paying the full costs of producing and using it. [See this great post for economics students for more details]. Full-cost pricing for gasoline would include not just the extraction and transport costs of crude oil, the costs of refining and shipping gasoline, and the costs of distributing it through a retail network to your local gas station. Full-cost pricing would mean  paying the full social costs of gasoline, the private costs and the public costs imposed on others, including in the price of gasoline the impacts of pollution on human health, the damage mining and shipping does to the ecosystems that provide economic benefits to people, and the cost we impose on future generations by using up non-renewable resources….

Various experts recommend a range of policies to approximate full-cost pricing. None are perfect. New York Times columnist Tom Friedman thinks there should be a gasoline “price floor” to keep prices from dropping low enough to make SUVs and light trucks attractive again. For years many economists have recommended pollution taxes on stuff like gasoline.  Called Pigovian taxes after the economist Arthur Pigou who first proposed them, pollution taxes would cause people to consume less gasoline.

Some policy professionals think those taxes could then be used to subsidize green technologies, research and development, but in reality the taxes do their main work by rationalizing (and decreasing) consumption levels of things with bad side-effects (or negative externalities, in economics jargon).

Money raised by a gas tax could therefore be used for any purpose. Why should they be earmarked for green technologies, when they could also be used for improving schools, increasing our meager foreign aid budget, or putting a public library in walking distance of every person in America? A democratically-elected government should be able to prioritize limited spending without arbitrary constraints.

Paradoxically, most gas taxes collected at the state level are earmarked, sometimes in the state constitution, for a particularly perverse bit of pork-barrel spending—road construction.  In most other democracies, spending for road-building must compete for attention with other uses of government funds:  constructing public transit infrastructure and subsidizing operating expenses, building hospitals, and everything else that government coffers supply.

In fact, given our current fiscal dysfunction, we ought justly to be suspicious of ambitious plans to raise more government revenue. Simply having another source of pork available to our earmark-prone Congress would be fiscally irresponsible.  Government is not great at choosing winners and losers in the technology sector, and such revenue would be a gift to K-Street lobbyists.

Why not instead use gas tax revenues to address the regressivity caused by the taxes themselves? Gas taxes, and energy taxes in general, hit poor people more than rich people, and small businesses more than big businesses (because a bigger proportion of their incomes are spent on energy). The rich can also avoid energy taxes because they have the capital to invest in short-term energy efficiency. Most of the poor folks in my inner city neighborhood did not go out to buy a Prius when gas prices were higher. They already spend more money feeding their cars than feeding their families. A simple gas tax, with no policies to make households whole, is an unjust burden on poor people.

But if the tax were fully reimbursed, the economic impact on the poor would be mitigated. In principle at least, the entire amount paid for gas taxes could be refunded. Why would this not leave the system entirely unchanged—wouldn’t households just plow all that money back into gas consumption?

No, not if they were even the teensiest bit rational about it. Imagine yourself receiving a sum of money, which just happens to equal what you paid in higher gas taxes in the previous year. What would you spend that money on? Relatively expensive gasoline, or something else that is now relatively cheaper (public transportation? A bicycle? Books?). 

Empirical evidence on the substitution effect suggests that people will buy more of the things which are relatively cheaper, and less of the things which seem more expensive. Reimbursing the gas tax addresses the problem of the income effect, whereby a price rise in some consumer goods leaves households with less overall money to spend.

We would like pollution taxes to work through the substitution effect and not through the income effect.  We don’t want our policies to leave households, and especially poor households, holding the bag while we solve pollution problems.

There are many refinements on the economic theory (whether one uses Hicksian or Marshallian demand curves [http://en.wikipedia.org/wiki/Hicksian_demand_curve] to judge the income effect, for example). 

But the important thing is that all the arguments used above also apply to other economic problems like climate policy with justice. More on that in a future post.