The Corrective Tax versus Liability as Solutions to the Problem of Harmful Externalities

Steven Shavell

doi:10.2139/ssrn.1636359

Abstract

Although the corrective tax has long been viewed by economists as a theoretically desirable remedy for the problem of harmful externalities, its actual use has been limited, mainly to the domain of pollution. Liability, in contrast, has great importance in controlling harmful externalities. I compare the tax and liability here in theory and suggest that the conclusions help to explain the observed predominance of liability over taxation, except in the area of pollution. The following factors are emphasized in the analysis: inefficiency of incentives under taxes when, as would be typical, it would be impractical for the state to incorporate into taxes all of the variables that significantly affect expected harm; efficiency of incentives under strict liability, which requires only that actual harms be measured; efficiency of incentives to exercise precautions under the negligence rule; administrative cost advantages of liability deriving from its being applied only when harm occurs; and dilution of incentives under liability when suit would be unlikely or injurers would not be able to pay fully for harms caused.

Highlights

The corrective tax has long been viewed by most economists as a, or the, theoretically preferred remedy for the problem of harmful externalities
To impose strict liability and create desirable incentives, the state need only measure the harms that occur, implying that the problems due to incompleteness of taxes are avoided; there is no inefficiency due to inaccuracy of taxes and no problem of excessive risk due to lack of tax-associated incentives to take care
It follows that the negligence rule is superior to the tax in controlling dimensions of care, is inferior to the tax in controlling the level of harmful activities, enjoys a possible administrative cost advantage over the tax owing to the ex post nature of liability, and suffers from the disadvantage that its effectiveness is lowered by the general factors that dilute expected liability

Summary

Discussion

This paper can be downloaded without charge from: The Harvard John M. Olin Discussion Paper Series: http://www.law.harvard.edu/programs/olin_center/ The Social Science Research Network Electronic Paper Collection: http://ssrn.com/. The Corrective Tax versus Liability As Solutions to the Problem of Harmful Externalities. The corrective tax has long been viewed by economists as a theoretically desirable remedy for the problem of harmful externalities, its actual use has been limited, mainly to the domain of pollution. In contrast, has great importance in controlling harmful externalities. I compare the tax and liability here in theory and suggest that the conclusions help to explain the observed predominance of liability over taxation, except in the area of pollution. The following factors are emphasized in the analysis: inefficiency of incentives under taxes when, as would be typical, it would be impractical for the state to incorporate into taxes all of the variables that significantly affect expected harm; efficiency of incentives under strict liability, which requires only that actual harms be measured; efficiency of incentives to exercise precautions under the negligence rule; administrative cost advantages of liability deriving from its being applied only when harm occurs; and dilution of incentives under liability when suit would be unlikely or injurers would not be able to pay fully for harms caused

Introduction

The Corrective Tax

Conclusion