One important goal of tax policy is economic efficiency. In some cases, this requires raising revenue and avoiding changes in relative prices that may distort taxpayer behavior and create "excess burden." In other cases, however, economic efficiency might require changes in relative prices: for example, taxing the "negative externalities" from alcohol, tobacco, and disposal of household or industrial waste. (Negative externalities include injuries, second hand smoke, and aesthetic costs.)
A second goal of tax policy is administrative efficiency. This is often best achieved by taxes on market transactions, for which the tax base can be measured and verified most easily. Taxes can apply to wages paid by an employer, interest paid by a bank, dividends reported by a broker, and the sale of cigarettes and alcohol as reported by retail establishments.(1)
But what about disposal of household and industrial waste? To achieve economic efficiency, these activities should be taxed, but they are often not market transactions that can be verified by a third party. In such cases, a "two-part instrument" might resolve the conflict.(2) Instead of directly taxing waste, a two-part instrument would raise the relative price of waste indirectly through both a tax and a subsidy on other activities that are market transactions. This policy combination can change relative prices in the same way as a tax on waste, but each tax or subsidy can be verified by invoices. Thus, the two-part instrument might better achieve both economic and administrative efficiency.
In the next sections, I clarify the theory behind this idea and provide a few examples. The following sections consider interactions with other taxes and the issue of scarcity rents.
Any Tax Can be Set to Zero
Taxpayers long have known that government can tax them both when they earn and again when they spend; most economists recognize that one such tax is redundant. Generally speaking, a tax that takes half of your gross paycheck is equal to a tax that doubles the price of everything you buy. As a consequence, for any system of tax rates on different commodities, any one tax can be set to zero. Revenue can be raised by a tax on all forms of income. Then all the desired relative prices of the different commodities can be achieved by a set of taxes and subsidies on goods other than the untaxed good.(3) One simple example is a political promise not to tax cigarettes, which can be circumvented by a tax on all income and a subsidy to all goods except cigarettes.
The best actual example of a two-part instrument is a deposit-refund system. A tax is first paid at the store on some item(s), and then returned if and when the item (or its container) is recycled. The result is a tax that remains on the good when it is not recycled. But this idea can be applied much more generally. Even the U.S. income tax operates on such a principle, using a withholding tax collected by employers that may exceed the tax due. If so, a refund is paid if and when the taxpayer files properly.
Suppose that a government wants to tax all household waste disposal in order to reduce landfill costs and negative externalities (like truck noise, odor, and groundwater contamination). A tax per bag of garbage might be difficult to implement, administer, and enforce.(4) It also can induce illegal dumping. Under some conditions, however, the jurisdiction can: tax everything bought at the store, through a general sales tax; provide a partial subsidy to all regular garbage, through free curbside collection; and provide a higher subsidy to all recycling.(5) This combination leaves a partial tax on garbage, but it leaves the highest rate of tax on anything not put into regular garbage or recycling - that is, anything dumped illegally.(6)
Second, suppose policymakers want to tax some polluting emissions from a factory, and cannot measure those emissions …