As economic decisionmakers-whether consumers, corporate planners, government policymakers, or investment bankers-we all depend on the market for guidance. In order for markets to work and economic actors to make sound decisions, the markets must give us good information, including the full cost of the products we buy.

Unfortunately, markets largely ignore the indirect costs of goods and services, thus grossly distorting the structure of the economy. The market price of burning coal, for example, includes only the direct costs, those of mining the coal and transporting it to the power plant. By neglecting the substantial indirect costs of burning coal-the costs of air pollution, acid rain, devastated ecosystems, and climate change-the market is giving us bad information. As a result of this and other distortions, we are making bad decisions.

The most effective way to correct this massive market failure is to restructure taxes-lowering taxes on income while raising those on environmentally destructive activities. Widely endorsed by economists, tax shifting helps make sure the price of products reflects their full costs to society.

The first step in creating an honest market is to calculate these indirect costs. Perhaps the best model for this is a U.S. government study on smoking from the Centers for Disease Control and Prevention (CDC). In 2006 the CDC calculated the cost to society of smoking cigarettes-including both the cost of treating smoking-related illnesses and the lost worker productivity from these illnesses-at $10.47 per pack.

This calculation provides a framework for raising taxes on cigarettes. In New York City, smokers now pay $4.25 per pack in state and local cigarette taxes. Since a 10-percent price rise typically reduces smoking by 4 percent, the health benefits of tax increases are substantial.

The many indirect costs of using gasoline-including climate change, oil industry tax breaks and subsidies, oil supply protection, and treatment of auto exhaust-related respiratory illnesses-total around $12 per gallon ($3.17 per liter), based on a conservative estimate by the International Center for Technology Assessment. If this external or social cost were added to the roughly $3 per gallon average price of gasoline in the United States, a gallon would cost $15. These are real costs. Someone bears them. If not us, our children.

Gasoline’s indirect cost of $12 a gallon provides a reference point for raising taxes to where the price reflects the environmental truth. Gasoline taxes in Italy, France, Germany, and the United Kingdom-averaging more than $4 per gallon-are a good start. That the average U.S. gas tax is less than 50¢ per gallon helps explain why the United States uses more gasoline than the next 20 countries combined. The high gasoline taxes in Europe have contributed to an oil-efficient economy and to far greater investment in high-quality public transportation, making it less vulnerable to oil supply disruptions.

Phasing in an incremental gasoline tax rising by 40¢ per gallon per year for the next 10 years and offsetting it with a reduction in income taxes would raise the U.S. gas tax to the $4 per gallon tax prevailing today in Europe. This will still fall short of the $12 per gallon indirect costs, but combined with the rising price of producing gasoline, it should be enough to encourage motorists to use improved public transport and to buy plug-in hybrid and all-electric cars as they come to market.