Pigovian Tax

What Is a Pigovian Tax?

A Pigovian (Pigouvian) tax is a tax assessed against private individuals or businesses for engaging in activities that create adverse side effects for society. Adverse side effects are those costs that are not included as a part of the product's market price. These include environmental pollution, strains on public healthcare from the sale of tobacco products, and any other side effects that have an external, negative impact. Pigovian taxes were named after English economist, Arthur Pigou, a significant contributor to early externality theory.

Understanding a Pigovian Tax

The Pigovian tax is meant to discourage activities that impose a cost of production onto third parties and society as a whole. According to Pigou, negative externalities prevent a market economy from reaching equilibrium when producers do not take on all costs of production. This adverse effect might be corrected, he suggested, by levying taxes equal to the externalized costs. Ideally, the tax would be equivalent to the external damage caused by the producer and thereby reduce the external costs going forward.

Negative externalities are not necessarily “bad.” Instead, a negative externality occurs whenever an economic entity does not fully internalize the costs of their activity. In these situations, society, including the environment, bears most of the costs of economic activity.

A popular example of a Pigovian-style tax is a tax on pollution. Pollution from a factory creates a negative externality because impacted third parties bear part of the cost of pollution. This cost might manifest through contaminated property or health risks. The polluter only takes into consideration the private costs, not the external costs. Once Pigou factored in external costs to society, the economy suffered deadweight loss from excess pollution beyond the “socially optimal” level. Pigou believed that state intervention should correct negative externalities, which he considered a market failure. He suggested that this be accomplished through taxation.

Counterargument to a Pigovian Tax

Pigou’s externality theories were dominant in mainstream economics for 40 years but lost favor after Nobel Prize-winner, Ronald Coase, presented his ideas. Using Pigou’s analytical framework, Coase demonstrated that Pigou’s examination and solution were often wrong, for at least three separate reasons:

1. Negative externalities did not necessarily lead to an inefficient result.
2. Even if they were inefficient, Pigovian taxes did not tend to lead to an efficient result.
3. The critical element is transaction cost theory, not externality theory.

Examples of a Pigovian Tax

Despite any counterarguments towards Pigou's theories, Pigovian taxes are prevalent in society today. One of the most popular Pigovian taxes is a carbon emissions tax. Governments impose a carbon emissions tax on any company that burns fossil fuels. When burned, fossil fuels emit greenhouse gases, the cause of global warming, which is damaging our planet in a multitude of ways. The carbon tax is intended to factor in the real cost of burning fossil fuels, which is paid by society. The end role of the carbon tax is to ensure that the producers of carbon products are the ones incurring this external cost.

Another Pigovian tax, common in Europe, is a tax on plastic bags, and sometimes even paper bags. This encourages consumers to bring their own reusable bags from home to deter the use of plastic and paper. Plastic is a by-product of burning fossil fuels and results in the damage of marine life, while paper bags encourage deforestation.

All of the above products cause a negative externality, whose price does not take into consideration the cost to society. The implemented taxes are a measure to redistribute those costs back to the producer and/or user that generate the negative externality.

Difficulty in Calculating a Pigovian Tax

Pigovian taxes encounter what Austrian economist Ludwig von Mises first described as “calculation and knowledge problems.” A government cannot issue the correct Pigovian tax without knowing in advance what the most efficient outcome is. This would require knowing the precise amount of the externality cost imposed by the producer, as well as the correct price and output for the specific market. If lawmakers overestimate the external costs involved, Pigovian taxes cause more harm than good.