Pigovian tax definition
What is a Pigovian tax?
A Pigovian (Pigouvian) tax is a tax imposed on individuals or businesses for engaging in activities that create harmful side effects for society. Unwanted side effects are costs that are not included in the market price of the product. These include environmental pollution, pressure on public health care through the sale of tobacco products and any other side effects that have a negative external impact. Pigovian taxes were named after the English economist Arthur Pigou, a major contributor to the theory of early externality.
Key points to remember
- A Pigovian tax aims to tax the producer of goods or services that create harmful side effects for society.
- Economists argue that the cost of these negative externalities, such as environmental pollution, is borne by society rather than by the producer.
- The purpose of the Pigovian tax is to redistribute the cost to the producer or user of the negative externality.
- A tax on carbon emissions or a tax on plastic bags are examples of Pigovian taxes.
- Pigovian taxes are supposed to match the cost of the negative externality, but they can be difficult to determine and if overestimated they can harm society.
Understanding a Pigovian tax
The Pigovian tax is intended to discourage activities that impose a cost of production on third parties and on society as a whole. According to Pigou, negative externalities prevent a market economy from reaching equilibrium when producers do not bear all the costs of production. This negative effect could be corrected, he suggested, by levying taxes equal to the externalized costs. Ideally, the tax would equal the external damage caused by the producer and thus reduce external costs in the future.
Negative externalities are not necessarily “bad”. Instead, a negative externality occurs whenever an economic entity does not fully internalize the costs of its activity. In these situations, society, including the environment, bears most of the costs of economic activity.
A popular example of a Pigovian-type tax is a pollution tax. The pollution of a factory creates a negative externality because the third parties concerned bear part of the cost of the pollution. This cost can manifest itself in contaminated goods or health risks. The polluter only takes into account the private costs and not the external costs. Once Pigou took into account the external costs to society, the economy suffered a deadweight loss due to excessive pollution beyond the “socially optimal” level. Pigou believed that state intervention should correct negative externalities, which he saw as a market failure. He suggested that this be done through taxation.
Counter-argument to a Pigovian tax
Pigou’s externality theories have been dominant in mainstream economics for 40 years, but fell out of favor after Nobel Prize winner Ronald Coase pitched his ideas. Using Pigou’s analytical framework, Coase demonstrated that Pigou’s examination and solution were often wrong, for at least three distinct reasons:
- Negative externalities did not necessarily lead to an inefficient outcome.
- Even though they were ineffective, Pigovian taxes did not tend to lead to an effective result.
- The critical element is the theory of transaction costs and not the theory of externalities.
Examples of Pigovian tax
Despite all the counter-arguments against 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 tax on any business that burns fossil fuels. When burned, fossil fuels emit greenhouse gases that cause global warming that damage our planet in multiple ways. The carbon tax aims to take into account the real cost of burning fossil fuels, which is paid by society. The final role of the carbon tax is to ensure that the producers of carbon products are those who bear this external cost.
Another Pigovian tax, common in Europe, is a tax on plastic bags, and sometimes even on paper bags. This encourages consumers to bring their own reusable bags from home to deter the use of plastic and paper. Plastic is a byproduct of burning fossil fuels and damages marine life, while paper bags encourage deforestation.
All of the above products cause a negative externality, the price of which does not take into account the cost to society. The taxes implemented are a measure to redistribute these costs to the producer and / or user that generate the negative externality.
Difficulty calculating a Pigovian tax
Pigovian taxes encounter what Austrian economist Ludwig von Mises first described as “problems of calculation and knowledge.” A government cannot issue the correct Pigovian tax without knowing in advance what the most effective 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 do more harm than good.