There are numerous arguments in favour, and, when you think of it, not a whole lot against..

At least no rational arguments. The main reason not to do it is that it’s politically very unpopular, which is very unfortunate. Education could help, so here we go.

Arguments in favour:

• Internalizing the external effects
• Creating a level playing field for alternative (cleaner) energy
• Stabilizing gasoline prices
• Encouraging employment
• Helping to lower the budget deficit

External effects are a class of market failure where the price doesn’t reflect all relevant cost, like the effects on third parties (those not involved in the transaction). Pollution is the classic example. It brings cost (health, environmental degradation, clean-up, etc.), but those costs (of say, a polluting factory) are largely incurred elsewhere (even in other countries).

For instance, a Dutch study showed that living close to a highway cuts life expectancy by a whopping 7 years (comparable to smoking), and this is in the Netherlands, where emission standards are pretty severe by international standards. (If you must know, the main health culprit are micro particles from diesel exhaust pipes). The costs of this are not included in gasoline prices.

Taxing is only one example of dealing with external effects, but the economic rationale is there. Taxing up until the marginal production cost include all relevant societal cost (including pollution cost) would led the price reflect those cost. It also, at least in principle, would provide the government with the funds to clean up the environment.

Creating a level playing field for alternative energy could reap important benefits. Here is an article arguing that electric cars powered by lithium-ion batteries need roughly $5 per gallon in gasoline prices (a little less if the range is lowered to 40 miles, but that’s not very realistic) at least.

At present, there are huge government funds lined up to stimulate home grown lithium ion production (today, these batteries come from Asia). Now that energy prices have collapsed, the concept of this has become much less attractive. Even the Toyota Prius has seen it’s sales collapse in the last couple of months of 2008.

Letting gasoline prices reflect all relevant cost (including the cost of pollution) thorough taxing it would go a long way to level the playing field. Suddenly, a whole range of alternatives become more viable, and this could lead to a thriving, innovative domestic industry, which produces cleaner products.

Stabilizing gasoline prices. This is simple, the bigger the tax part of retail prices, the less these will fluctuate in response to changes in crude prices. This is the reason why the crude ride to almost $150 per barrel was much less of a headline news in Europe then it was in the US.

An additional benefit is that it would also create a more stable investment environment for car manufacturers. Inventories and investment decisions are hampered by wild gyrations in crude prices because without tax, these work one-on-one in gasoline prices, swinging consumers from hybrids to SUV’s and back.

Encouraging employment. In an age of globalization, it pays to tax less mobile, dirty activities (taxing mobile dirty activities just encourages them to move elsewhere), in order to tax mobile activities and production factors less.

For instance, a gasoline tax could be used for lowering other taxes, like taxes on labour, improving the incentives to work and decreasing labour cost which encourages hiring more people. It makes sense.

Lower budget deficit. Or, the tax revenues could just be used for lowering the budget deficit. However, some of this will even occur if the gasoline tax is completely offset by lowering labour taxes, as the resulting increase in employment will increase tax income.

Any reason not to do it? We really can’t figure out why. This is also a very simple tax to administrate and collect, so there are really no major problems on the execution side of things either.

Other solutions?

• Creating markets
• Regulation

External effects have other potential solutions besides taxing to include all relevant cost. External effects violate the rights of parties not involved in the transactions, and the reason for that could be so called missing markets.

For instance, people living near highways (whose health suffers) have a right to clean air, but there is no market for that. This could be remedied, but this is cumbersome, polluters would have to pay the third parties suffering from these external effects.

Less cumbersome is inverting the situation, let polluters buy pollution rights, and let these rights be tradable on markets. The marginal price should tend to reflect marginal pollution cost and allocate these pollution rights efficiently. Why?

Who would pay the most for pollution rights? Those that have the greatest difficulty in reducing pollution, perhaps because most easy measures have already been taken by them. So they will buy up most of the pollution rights, and this forces exactly the right parties to reduce pollution, namely those for whom it is easiest to do so.

If implemented on a world scale, this would, at least in theory, mean that (mostly Western) countries which already implemented most existing clean technology (to treat exhaust fumes, and the like) would (mostly) pay for the pollution permits, and (mostly) third world industry who haven’t picked the low hanging fruit of implementing existing technologies to clean up (as anyone who has been to any major third world city can testify), will be forced to do so (because it’s cheaper than paying for the pollution permits).

This would be efficient on a world scale, the one possible disadvantage is that it reduces the incentives for developing newer clean technologies. Even reducing the number of pollution permits over time would reinforce these incentives only after a considerable amount of time.

Also, these market based solutions are possible for industry, but they are not really practical for the transport sector.

Regulation. Just specify what pollution is allowed, or what mileage cars in different weight classes should abide by, and set moving targets, creating incentives to innovate. This is already done in most countries, but the process is under heavy lobby efforts from car manufacturers, and in the US at least, these have (apart from California) successfully blocked more stringent regulation or exploited loopholes (for SUV’s, for instance).

This is a pity, because stringent regulation opens up markets for cleaner alternatives, which is something that has multiple benefits (innovation, cleaner environment, employment, etc.).

Experience from Europe and Japan

• Combined gasoline tax and stringent regulation
• Better average mileage
• More stable gasoline prices
• Innovative cars

After the first oil shock, on balance, the average mileage of US cars remained stable (more efficient motors were offset by a large increase in car size, that is, SUV’s). Cheap gasoline let Detroit heavily invest in SUV’s (which also benefited from a loophole in mileage regulation), but in the absense of a gasoline tax, this environment shifted dramatically when oil became expensive, which was part of Detroit’s downfall.

A more stable environment through gasoline tax, with gradually increasing regulation on mileage and emission creates a more stable investment environment for car manufacturers and gradually tilts incentives towards cleaner technologies. Which is exactly what we need.

The are no rational arguments against a gasoline tax, even less so today, with the economic crisis making oil (and hence gasoline, at least there where it’s not taxed) cheap again, blunting incentives for cleaner technologies.

What we’re suggesting is actually a more market friendly approach than Obama plan, with big state funding programs for alternative energies, including batteries of which one knowledgeable observer has argued that there is little evidence yet to select supposed winners (like lithium-ion batteries).

Governments are usually not better in selecting winners than markets. Let the markets sort that out, and let governments level the playing field, by ensure that the external effects of combustion engines are included in the price of gasoline.