Saturday, November 25, 2006

Refundable Credits as Negative Income Tax and Pigouvian Tax in One

A recent study, highlighted by Mankiw, has caused me to think more about the idea of refundable credits. In the Seattle area 275 households were give road toll credits. Money was deducted from their credits based on how they drove and what they didn’t use they got to keep as cash. This is in effect a Pigouvian tax in reverse. The government is paying you to refrain from a harmful activity.

For this small scale study the participants were paid to induce them to actually go along with the study. Yet, this method might have some merit out in the real world. The objection to many Pigouvian taxes is that they are likely to be regressive. There is no particular reason to think that wealthier people drive much, much more than poorer people and so the poor seem to be unfairly disadvantaged if you simply tax driving.

My response has been to rebate the money in the form of increases to the Earned Income Tax Credit (EITC). Commentators such as Mankiw would prefer that we used the extra funds to deal with the serious issue of the looming fiscal crisis. While this issue is important I fear that this method is not going to get far. Inequality is already increasing and government measures to exacerbate inequality are not likely to be popular.

In fact, I believe that we can take pro-market measures to address widening inequality today or we can wait and have anti-market measures forced down our throats tomorrow. I think that it is not completely ridiculous to compare the two-tiering of American society today with a famous two-tiering that took place within another economic superpower power a little over 200 years ago. And to misquote Oscar Wilde, we all know how that unfortunate situation ended.

So we could tax pollution and congestion and then rebate the money back to poorer families, or we could give poorer families money and then tax some of it away for pollution and congestion. The latter seems quite a bit more palatable. Now in practice we probably can’t target the funds directly towards poorer families. Every household will have to get a congestion and pollution credit equal to perhaps several thousand dollars. We could determine the exact amount by number of licensed, insured drivers or something like that. As an aside this is a great way to encourage everyone to be licensed and insured.

Then we tax the credit back out based on how much you drive. If you go over then you have to pay the difference or you get your license revoked. My guess is that the real drop in driving will occur among the poor. Many Americans will just let their credit get taxed back and maybe pay a little extra. However, those with the lowest incomes will be the most motivated to find a way to keep their credit.

In the end we end up closing some of the income gap and having cleaner, safer streets, all without a single regulation. Ain’t markets grand?