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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?

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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.

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  • $\begingroup$ 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. $\endgroup$ – Steve222 May 9 at 21:15
  • $\begingroup$ @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 $\endgroup$ – 1muflon1 May 9 at 21:20
  • $\begingroup$ 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? $\endgroup$ – Steve222 May 9 at 21:52
  • $\begingroup$ @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 be basically then 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 $\endgroup$ – 1muflon1 May 9 at 21:59
  • $\begingroup$ 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. $\endgroup$ – Steve222 May 9 at 22:52

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