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Christopher R. Knittel and Ryan Sandler, February 2013

A basic tenet of economics posits that when consumers or firms don't face the true social cost of their actions, market outcomes are inefficient. In the case of negative externalities, Pigouvian taxes are one way to correct this market failure, where the optimal tax leads agents to internalize the true cost of their actions. A practical complication, however, is that the level of externality nearly always varies across economic agents and directly taxing the externality may be infeasible. In such cases, policy often taxes a product correlated with the externality.

For example, instead of taxing vehicle emissions directly, policy makers may tax gasoline even though per-gallon emissions vary across vehicles. This paper estimates the implications of this approach within the personal transportation market. We have three general empirical