Taxes directly address the market failure by “pricing in” environmental costs
Taxes directly address the market failure that causes markets to ignore environmental impacts. A welldesigned
environmental tax increases the price of a good or activity to reflect the cost of the environmental
harm that it imposes on others. The cost of the harm to others – an “externality” – is thereby internalised into
market prices. This ensures that consumers and firms take these costs into account in their decisions.
Taxes leave consumers and businesses with flexibility to determine the least-cost way to reduce
the environmental damage
Most regulatory approaches involve the government specifying how to reduce emissions or who should
do the reduction. Similarly, subsidies and incentives for environmentally preferable goods or practices involve
the government steering the economy in favour of certain environmental solutions over others. Both
approaches involve the government trying to “pick winners” – directing the market in a prescriptive way. This
requires significant information about ever-changing conditions and technologies, and carries significant risk
of making suboptimal choices. Regulations generally result in higher costs than taxes, since they force
particular types of abatement, even if cheaper alternatives are available.