Pigouvian tax

A Pigouvian tax (also spelled Pigovian tax) is a tax on a market activity that generates negative externalities, that is, costs incurred by third parties. It imposes costs corresponding with the externalities, internalizing those costs to improve Pareto efficiency. Ideally, the tax is set equal to the external marginal cost of the negative externalities, in order to correct an undesirable or inefficient market outcome (a market failure). In the presence of negative externalities, parties who did not consent to the transaction or activity, and did not receive payment, nevertheless incur some of the costs, so the total cost is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to a harmful excess of the activity. Examples of negative externalities are environmental pollution and increased public healthcare costs associated with tobacco and sugary drink consumption. Conversely, in the presence of positive externalities, those who did not directly participate in the market activity, or contribute to the production, receive some benefit, and the market may under-produce. This suggests a Pigouvian subsidy to help consumers pay for socially beneficial products and encourage increased production to generate more positive societal benefits. Examples are a subsidy for flu vaccines, for research and development, and for public goods such as education and national defense. Pigouvian taxes are named after the English economist Arthur Cecil Pigou (1877–1959), who developed the concept of economic externalities. William Baumol was instrumental in framing Pigou's work in modern economics in 1972.

Pigou's original argument In 1920, the British economist Arthur Cecil Pigou published The Economics of Welfare. In it, he argues that industrialists seek their own marginal private interest. When the marginal social interest diverges from the marginal private interest, the industrialist has no incentive to internalize the marginal social cost. Conversely, Pigou argues, if an industry produces a marginal social benefit, the individuals receiving the benefit have no incentive to pay for that service. Pigou refers to these situations as incidental uncharged disservices and incidental uncharged services, respectively. Pigou provides numerous illustrations of incidental uncharged disservices. For example, if a contractor builds a factory in the middle of a crowded neighborhood, the factory causes these incidental uncharged disservices: higher congestion, loss of light, and a loss of health for the neighbors. He also references businesses that sell alcohol. The sale of alcohol necessitates higher costs in policemen and prisons, Pigou argues, because of the crime associated with alcohol. In other words, the net private product of alcohol businesses is peculiarly large relative to the net social product of the same business. He suggests that this is why most countries tax alcohol businesses. The divergence between the marginal private interest and the marginal social interest produces two primary results. First, as already noted, the party receiving the social benefit does not pay for it, and the one creating the social harm does not pay for it. Second, when the marginal social cost exceeds the marginal private benefit, the cost-creator over-produces the product. Ultimately, because non-pecuniary externalities overestimate the social value, they are over-produced. To deal with over-production, Pigou recommends a tax placed on the offending producer. If the government can accurately gauge the social cost, the tax could equalize the marginal private cost and the marginal social cost. In more specific terms, the producer would have to pay for the non-pecuniary externality that it created. This would effectively reduce the quantity of the product produced, moving the economy back to a healthy equilibrium.

Working of the Pigouvian tax

The diagram illustrates the working of a Pigouvian tax. A tax shifts the marginal private cost curve up by the amount of the externality. If the tax is placed on the quantity of emissions from the factory, the producers have an incentive to reduce output to the socially optimum level. If the tax is placed on the percentage of emissions per unit of production, the factory has the incentive to change to cleaner processes or technology.

Taxing proxies Taxing proxies for the negative externalities, such as taxing production as a proxy for emissions, has been argued to sometimes fail to deliver efficient market outcomes. Even less effective are lump-sum taxes on industry participation, such as licensing, especially when the number of firms can vary. Pigouvian tax on measures of emissions themselves (or the relevant negative externalities) can create the long-run efficient market and social optimum.

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