What is a Pigovian Tax?

A Pigovian tax, also spelled "Pigouvian", is a tax on economic activity generating negative external charges that are borne by unrelated third parties and which does not reflect costs caused by negative externalities in the final cost of the product or service. An externality is an action that has a negative impact on others, but not necessarily on the individual undertaking such action. The tax is meant to correct an unwanted or ineffective result on the market (market failure). The tax represents a tax on any good creating negative externalities. Its purpose is to ensure that the price of the good is equal to the marginal social cost and to provide a more efficient social allocation of resources.

How Does is a Pigovian Tax Work?

The Pigovian tax got its name from Arthur Cecil Pigou, an English economist, who also developed the concept of economic externalities. In 1972 William Baumol played a role in influencing Pigou's work in the modern economy. Ideally, a Pigouvian tax will cost the producer the equivalent amount of the harm that it causes others. If Pigouvian taxes are levied, the output of the negative externality generating economic activity will decrease. Hence, the required quantity should decrease as the price increases, and the market equilibrium will become economically efficient, because the collective marginal cost will be equal to the marginal private cost.

Negative Externalities and Social Costs

The social cost of a market activity is not compensated by the private expense of the transaction, in the context of negative externalities. In such a scenario, the business effect is not productive and may result in over-consumption of the product. One major example of such externalities are environmental emissions. The driver of a vehicle whose vehicle is polluting the environment, does not necessarily immediately suffer from the exhaust it emits as it drives on the lane, but everyone behind them can suffer. The exhaust can also increase emissions for all people in the community. Therefore, a tax on emissions could discourage pollution and raise public funds to deal with the external costs of environmental emissions. One of Pigou's critics was Ronald Coase who argued that, after the tax is enforced, the tax levied on an industry that creates a negative externality should not be adjusted. The basis of his point is that all social costs are in fact equal. Coase argued that:

• The social harm of smoky air is not entirely the responsibility of a smoke-emitting factory.
• No one would suffer from smoky air if the factory were not there, and
• If the people were not there no one would suffer from smoky air.

Due to the two-way cause of harm, Coase argued that neither party bears sole responsibility for the social harm, so that neither party should pay the full cost.

Calculation and Knowledge Problems

Ideally, the effects of the negative externality would equal the Pigouvian income. Such costs in the real world will, however, be difficult to measure. Pigouvian taxes can also be termed regressive, as they place a heavier burden on lower-income groups relative to those with higher incomes. Pigouvian taxes, like any other type of government intervention, can have unanticipated negative effects. The Netherlands, for example, imposed a groundwater tax in 1995 which imposed the tax on drinking water companies to preserve clean drinking water for future generations. Nevertheless, too many derogations were permitted by the government, resulting in 90% tax payment by 10 companies who campaigned against the levy; which was abolished in 2011 by the government for fiscal inefficiencies.

Related Topics

• Market Competition and Innovation
• New Technology and Positive Externalities

• Externality
• Network Externality
• Pigovian Tax
• Coase Theorem
• Agglomeration Diseconomies

• Education - Private and Social Rate of Return
• Government Approaches to Encouraging Innovation
• Public Good
• Public, Private, Club, Common Goods
• Excludable and Rivalrous Goods
• What is the Free Rider Problem for Public Goods?
• Free Rider
• Social Loafing
• Role of Government in Paying for Public Goods
• What is the Tragedy of Commons for Common Resources?
• Income Inequality
• Poverty Line?
• Poverty Trap
• Public Safety Net
• Measuring Income Inequality
• Lorenz Curve
• Ladder of Opportunity
• Tradeoff between Incentives and Income Equality