<p>No, taxing externalities is not a good substitute for VAT for several reasons.</p>

<ol>
<li><p>Pigovian taxes (taxes on externalities) have to be set up in an optimal way to actually reduce externalities. However, it is astronomically improbable that the same level of tax that mitigates the negative externality is exactly the same level that government has to raise for optimal provision of public goods.</p></li>
<li><p>It can be shown that Pigovian taxes can be imposed without deadweight loss on economy (which almost all taxes have) but such result hinges on a fact that they are made revenue neutral - hence to use Pigovian taxes in most efficient manner you should used them in a way that does not raise any additional revenue.</p></li>
<li><p>By discouraging the activity that creates negative externality the tax basically by substitution effect erodes its own tax base. Every tax does this to some extent - VAT for example encourage substitution of savings for consumption or substitution away from market goods to non market goods but since VAT is very broad this should reduce tax base much less than just selective tax on goods that create negative externality.</p></li>
</ol>

<p>Consequently, Pigovian taxes are ill suited for  raising government revenue. Government should still pursue Pigovian taxes everywhere where there are externalities as correcting the externality is always optimal from social perspective. However, no modern government can realistically raise the kind of money it needs to run itself without VAT - in fact it is no accident that modern governments expanded precisely when modern VAT and income taxes were developed, if you check most government budgets VAT and income tax are always the biggest sections on revenue side of budget. </p>

CC BY-SA 4.0
2020-05-09T21:15:41.237Z
Are you implying that a carbon tax is ill-suited for raising government revenue because carbon emissions could easily be substituted? I would think that capping carbon emissions in line with international agreements and auctioning the rights (“almost identical” to a Pigovian tax according to Mankiw) would lead to very high carbon prices (=government revenue) other things equal.
sba222
CC BY-SA 4.0
2020-05-09T21:20:56.337Z
@Steve222 I was talking about Pigovian taxes in general. It is true that when it comes to carbon the substitution is not that easy, but even with carbon there will be substitution to renewables and as technology progresses it will become more and more easier. Also even in case of carbon emissions I would expect that the carbon tax would have larger substitution effect than just VAT. Also yes cap and trade is identical to Pigovian tax but again it’s bad tool for generating government revenue. This is because cap and trade is basically identical to the Pigovian tax so all of the above applies
1muflon1
CC BY-SA 4.0
2020-05-09T21:52:55.570Z
But any substitution of carbon through renewables would require new inputs of scarce natural resources (metals, rare earths, etc.) that could equally be taxed. Since all economic activity ultimately depends on rival access to natural resources they may be substitutes one for another but not as group. Hence I presume a tax on natural resources (rather than carbon only) could be a substitute for VAT?
sba222
CC BY-SA 4.0
2020-05-09T21:59:11.387Z
@Steve222 but this just further shows that there is a trade off between solving externality and raising revenue. Yes if you tax the inputs for renewables and non-carbon alternatives then sure you increase revenue from carbon tax but you will make it worthless in terms of fighting externality. Also, what you propose would just push VAT down the supply chain with additional drawback that now tax base does not include all the value added after the first stage of production. So this would not make much sense if you just want lower taxes then you can argue for lower VAT directly
1muflon1
CC BY-SA 4.0
2020-05-09T22:52:32.293Z
Given that natural resources are limited and as a group cannot be substituted in the economic process I understand that they cannot be eroded as a base for a Pigovian tax. If carbon were to be capped near zero, more metal would be needed for solar panels, etc. The very point would be to not tax “value added” but the externalities caused by the rival use of natural resources.
sba222
CC BY-SA 4.0
2020-05-10T00:08:14.610Z
@Steve222 what are you talking about? Consumption of natural resources in itself does not entail any externalities. An externality requires the social and private cost of production to be different. Under your definition of externality every single activity except for public goods would create externality making the whole concept meaningless. Also even if we would assume that any natural resource would create externality then again you have the same problem you can’t just set the Pigovian tax to any arbitrary level - chance that the corrective level is the same as revenue government needs is 0
1muflon1
CC BY-SA 4.0
2020-05-10T06:43:40.483Z
I started a new question [here](https://economics.stackexchange.com/questions/36556/is-the-use-consumption-of-natural-resources-considered-an-externality-per-se) to discuss externalties in the use/consumption of natural resources.
sba222
CC BY-SA 4.0
2020-05-10T07:11:09.223Z
In a cap-and-auction setup the corrective level is given by the cap. The government revenue results from it. The government may still need to complement it with other taxes that incur a DWL but that is no different from VAT today.
sba222
CC BY-SA 4.0
2020-05-09T20:38:32.857Z
2020-05-09T21:05:47.367Z
2020-05-09T21:05:47.367Z
1muflon1
<p>In the US, about \$650 billion of sales tax is collected nation wide. At a price of <a href="https://www.scientificamerican.com/article/how-to-set-a-price-on-carbon-pollution/" rel="nofollow noreferrer">\$50 per metric ton of carbon</a>, only about $75 billion could be collected at that rate. So it seems unlikely that it could entirely replace the revenue of sales tax or VAT.</p>
<p>Since pollution is probably the most costly negative externality (at least that I can think of), it seems unlikely that your traditional Pigouvian taxes can cover that much of the government's budget, however of course doing it is still quite worth it.</p>
<p>There are other externalities that could be taxed and would almost certainly be enough to cover the entire expenditures of government - even with them being as high as they are today. <a href="https://governology.substack.com/p/land-value-tax" rel="nofollow noreferrer">Land value tax can be viewed as Pigouvian</a>, and since any tax breaks in a given area increase the value of land in that area, replacing other taxes with a land value tax should almost exactly increase the amount of land value tax raised by the amount of other taxes eliminated.</p>

CC BY-SA 4.0
2023-08-31T16:20:34.973Z
2023-08-31T16:20:34.973Z
Governology
<p>There are some similarities between a carbon tax and a VAT. There is a recent paper on NiskanenCenter.org that <a href="https://www.niskanencenter.org/administrative-costs-of-a-carbon-tax/" rel="nofollow noreferrer">compares them in terms of their administrative costs</a> and other features.</p>
<p>If you are looking just for revenue (not for the effect on climate change) one disadvantage of a carbon tax is that its revenue would gradually disappear over time as carbon emissions fall toward zero. If you used carbon tax revenue for, say, rebates to low-income households, you would then face political pressure to introduce some other form of payment such as a UBI financed by general revenue (or, for that matter, by a VAT).</p>

CC BY-SA 4.0
2021-02-04T13:25:54.097Z
2021-02-04T13:25:54.097Z
Slopezian
<p>VAT is a tax on consumption. However, while in some instances it taxes negative externalities (e.g. fossil energy consumption) in many other cases it taxes services without externalities or potentially positive externalities (e.g. advisory services on how to reduce carbon emissions).</p>

<p>If consumption is being taxed arguably it would make more sense to tax consumption that actually causes negative externalities. Carbon taxes would be an obvious candidate (though arguably not the only one). The price of a product in a value chain would increase as carbon is added to it, just as with VAT, only that the tax is on "carbon added" rather on "value added".</p>

<p>Presumably a carbon tax would also be easier to administer than a VAT since carbon is taxed only where it enters the economy?</p>

<taxation><environmental-economics><pigouvian-taxes>
Could a carbon tax be a substitute for VAT?
sba222
# Could a carbon tax be a substitute for VAT?

(Asked by: username_0 on 2020-05-09)

VAT is a tax on consumption. However, while in some instances it taxes negative externalities (e.g. fossil energy consumption) in many other cases it taxes services without externalities or potentially positive externalities (e.g. advisory services on how to reduce carbon emissions).

If consumption is being taxed arguably it would make more sense to tax consumption that actually causes negative externalities. Carbon taxes would be an obvious candidate (though arguably not the only one). The price of a product in a value chain would increase as carbon is added to it, just as with VAT, only that the tax is on "carbon added" rather on "value added".

Presumably a carbon tax would also be easier to administer than a VAT since carbon is taxed only where it enters the economy?

**Tags:** taxation, environmental-economics, pigouvian-taxes


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## 3 answers

### Answer by username_1 on 2020-05-09. Score: 2

No, taxing externalities is not a good substitute for VAT for several reasons.

1. Pigovian taxes (taxes on externalities) have to be set up in an optimal way to actually reduce externalities. However, it is astronomically improbable that the same level of tax that mitigates the negative externality is exactly the same level that government has to raise for optimal provision of public goods.
2. It can be shown that Pigovian taxes can be imposed without deadweight loss on economy (which almost all taxes have) but such result hinges on a fact that they are made revenue neutral - hence to use Pigovian taxes in most efficient manner you should used them in a way that does not raise any additional revenue.
3. By discouraging the activity that creates negative externality the tax basically by substitution effect erodes its own tax base. Every tax does this to some extent - VAT for example encourage substitution of savings for consumption or substitution away from market goods to non market goods but since VAT is very broad this should reduce tax base much less than just selective tax on goods that create negative externality.

Consequently, Pigovian taxes are ill suited for raising government revenue. Government should still pursue Pigovian taxes everywhere where there are externalities as correcting the externality is always optimal from social perspective. However, no modern government can realistically raise the kind of money it needs to run itself without VAT - in fact it is no accident that modern governments expanded precisely when modern VAT and income taxes were developed, if you check most government budgets VAT and income tax are always the biggest sections on revenue side of budget.

> **Comments:**
> **username_0**: Are you implying that a carbon tax is ill-suited for raising government revenue because carbon emissions could easily be substituted? I would think that capping carbon emissions in line with international agreements and auctioning the rights (“almost identical” to a Pigovian tax according to Mankiw) would lead to very high carbon prices (=government revenue) other things equal.  
> **username_1**: @Steve222 I was talking about Pigovian taxes in general. It is true that when it comes to carbon the substitution is not that easy, but even with carbon there will be substitution to renewables and as technology progresses it will become more and more easier. Also even in case of carbon emissions I would expect that the carbon tax would have larger substitution effect than just VAT. Also yes cap and trade is identical to Pigovian tax but again it’s bad tool for generating government revenue. This is because cap and trade is basically identical to the Pigovian tax so all of the above applies  
> **username_0**: But any substitution of carbon through renewables would require new inputs of scarce natural resources (metals, rare earths, etc.) that could equally be taxed. Since all economic activity ultimately depends on rival access to natural resources they may be substitutes one for another but not as group. Hence I presume a tax on natural resources (rather than carbon only) could be a substitute for VAT?  
> **username_1**: @Steve222 but this just further shows that there is a trade off between solving externality and raising revenue. Yes if you tax the inputs for renewables and non-carbon alternatives then sure you increase revenue from carbon tax but you will make it worthless in terms of fighting externality. Also, what you propose would just push VAT down the supply chain with additional drawback that now tax base does not include all the value added after the first stage of production. So this would not make much sense if you just want lower taxes then you can argue for lower VAT directly  
> **username_0**: Given that natural resources are limited and as a group cannot be substituted in the economic process I understand that they cannot be eroded as a base for a Pigovian tax. If carbon were to be capped near zero, more metal would be needed for solar panels, etc. The very point would be to not tax “value added” but the externalities caused by the rival use of natural resources.  
> **username_1**: @Steve222 what are you talking about? Consumption of natural resources in itself does not entail any externalities. An externality requires the social and private cost of production to be different. Under your definition of externality every single activity except for public goods would create externality making the whole concept meaningless. Also even if we would assume that any natural resource would create externality then again you have the same problem you can’t just set the Pigovian tax to any arbitrary level - chance that the corrective level is the same as revenue government needs is 0  
> **username_0**: I started a new question [here](https://economics.stackexchange.com/questions/36556/is-the-use-consumption-of-natural-resources-considered-an-externality-per-se) to discuss externalties in the use/consumption of natural resources.  
> **username_0**: In a cap-and-auction setup the corrective level is given by the cap. The government revenue results from it. The government may still need to complement it with other taxes that incur a DWL but that is no different from VAT today.  

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### Answer by username_2 on 2023-08-31. Score: 0

In the US, about \$650 billion of sales tax is collected nation wide. At a price of [\$50 per metric ton of carbon](https://www.scientificamerican.com/article/how-to-set-a-price-on-carbon-pollution/), only about $75 billion could be collected at that rate. So it seems unlikely that it could entirely replace the revenue of sales tax or VAT.

Since pollution is probably the most costly negative externality (at least that I can think of), it seems unlikely that your traditional Pigouvian taxes can cover that much of the government's budget, however of course doing it is still quite worth it.

There are other externalities that could be taxed and would almost certainly be enough to cover the entire expenditures of government - even with them being as high as they are today. [Land value tax can be viewed as Pigouvian](https://governology.substack.com/p/land-value-tax), and since any tax breaks in a given area increase the value of land in that area, replacing other taxes with a land value tax should almost exactly increase the amount of land value tax raised by the amount of other taxes eliminated.


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### Answer by username_3 on 2021-02-04. Score: 0

There are some similarities between a carbon tax and a VAT. There is a recent paper on NiskanenCenter.org that [compares them in terms of their administrative costs](https://www.niskanencenter.org/administrative-costs-of-a-carbon-tax/) and other features.

If you are looking just for revenue (not for the effect on climate change) one disadvantage of a carbon tax is that its revenue would gradually disappear over time as carbon emissions fall toward zero. If you used carbon tax revenue for, say, rebates to low-income households, you would then face political pressure to introduce some other form of payment such as a UBI financed by general revenue (or, for that matter, by a VAT).


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