Pigouvian tax

A Pigovian tax (also spelled Pigouvian tax) is a tax levied on a market activity that generates negative externalities. The tax is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. A Pigovian tax equal to the negative externality is thought to correct the market outcome back to efficiency.

In the presence of positive externalities, i.e., public benefits from a market activity, the market tends to under-supply the product. Similar logic suggests the creation of Pigovian subsidies to increase the market activity.

Pigovian taxes are named after economist Arthur Pigou who also developed the concept of economic externalities. William Baumol was instrumental in framing Pigou's work in modern economics.

Workings of Pigovian tax

One difficulty with Pigovian taxes is calculating what level of tax will counterbalance the negative externality. Political factors such as lobbying of government by polluters may also tend to reduce the level of the tax levied, which will tend to reduce the mitigating effect of the tax; lobbying of government by special interests who calculate the negative utility of the externality higher than others may also tend to increase the level of the tax levied, which will tend to result in a sub-optimal level of production.

Pigovian tax effect on output.

The diagram illustrates the working of a Pigovian tax. A tax shifts the marginal private cost curve up by the amount of the tax. Faced with this cost increase, the producers have an incentive to reduce output to the socially optimum level by reducing the marginal externality to the marginal tax. The total tax revenue (which could be used to mitigate the effect of the negative externality) is equal to the size of the tax times the new output (the shaded area).

A key problem with the Pigovian tax is the "knowledge problem" suggested in Pigou's essay "Some Aspects of the Welfare State" (1954) where he writes, "It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of [the gaps between private and public costs] could interfere with individual choice." In other words, the economist's blackboard "model" assumes knowledge we don't possess — it's a model with assumed "givens" which are in fact not given to anyone. Friedrich Hayek would argue that this is knowledge which could not be provided as a "given" by any "method" yet discovered, due to insuperable cognitive limits; chaos theory argues for other cognitive limitations.

Aside from efficiency, Pigovian taxes may increase the fairness of how costs of negative externalities are borne. For example, even if a tax on air pollution is not at the perfect level to achieve optimal efficiency, it transfers cost associated with pollution from the public (e.g., via reduction of other taxes or benefit from public spending of the pollution tax proceeds) to the polluter.

Like all taxes, Pigovian taxes can encourage smuggling and black markets, especially if they create large differences in the price of popular products in neighboring jurisdictions, yet another reason why global cooperation becomes key. If lower income individuals tend to spend a greater portion of their income on the product with external social costs, such as cigarettes or electricity, then the corresponding Pigovian tax is regressive.

Negative Pigovian tax (Pigovian subsidy)

If there are positive externalities instead of negative externalities, one would want to encourage these behaviors by subsidizing them instead of taxing them. For instance, education is often subsidized by government because it is believed to have positive externalities. Such subsidies of goods with positive externalities can be considered a "negative Pigovian tax".

The motivation for such a subsidy is trying to reach economic efficiency. When a positive externality is present, a firm's solution of its utility maximization problem does not account for the additional utility (to another agent) produced as a by-product (the externality), thus causing the firm to produce less than the pareto-efficient level. The Pigovian subsidy thus internalizes the externality into the agent's utility function, by giving the firm incentive to produce more than it otherwise would.

An example would be a central government transfer that accounts for interjurisdictional spillover (usually in the form of matching grants).

Prohibition

Sometimes Pigovian analysis leads to the conclusion that the socially efficient level of consumption is zero, when marginal social cost exceeds marginal private benefit from the outset. This analysis has been used by some researchers to rationalize prohibition of drugs. However, the validity of such claims has been disputed, as many factors make the calibration of external cost of drug use uncertain. Even if the most efficient level of consumption were zero, such a level may not be practically achieved with prohibition, and prohibitions can generate their own social costs as well.

Alternatives

Direct regulation

Governments can choose to directly regulate the amount of a negative externality. However this sort of direct regulation is viewed as having a higher cost to society because while Pigovian taxes raise revenue and respond automatically to changes in the market such as lowered cost of production or pollution mitigation, regulations may be too slow to respond to such dynamics in the market. Additionally, with a Pigovian tax there is always an incentive to reduce pollution, whereas with direct regulation, a polluting company has no incentive to pollute any less than what is allowable.

Economic theory predicts that in an economy where the cost of reaching mutual agreement between parties is high, and where pollution is diffuse, Pigovian taxes will be an efficient way to promote the public interest, and will lead to an improvement of the quality of life measured by the Genuine Progress Indicator and other human economic indicators, as well as higher gross domestic product (GDP) growth.

Pigouvian taxation results in a "double dividend": it adjusts production to its socially optimal level, and it brings in tax revenue. In a revenue-neutral context, this money can now be used to reduce the (distortionary) taxes in another market. The double dividend, therefore, refers to the efficiency improvement in two separate markets.

Research on green taxation suggest that during the 1990s there was significant correlation between a country's UN Human Development Index (HDI) rank per fixed amount of GDP, and its level of green tax as a percentage of total tax revenues. Furthermore, over periods longer than 5 years, data suggest that countries having higher green tax rates such as Norway, Sweden and Netherlands experience higher GDP growth and higher HDI growth rate. However, these studies only show a correlation between green tax rates and higher GDP/HDI growth, not a causal effect.

Cap and trade

Another alternative to applying pigovian taxation is for government to place a limit on the total amount of the negative externality and create a market for rights to generate this specific negative externality. In the United States since the late 1970s, and in other developed nations since the 1980s, the concept of a market for "pollution rights" has arisen. Whereas the correct Pigovian Tax can be very difficult or costly to know (anything that is not the exact cost of the externality is inefficient), cap and trade does not need as much information to be effective. Giving out the rights for free (or at less than market price) allows polluters to lose less profits or even gain profits (by selling their rights) relative to the unaltered market case. Markets for emissions trading have been set up to bring better allocative efficiency and improved information sharing to the pollution externality problem. Pollution rights markets are a part of the field of Environmental Economics generally, and Free-market environmentalism specifically.

See also

• Social cost
• Carbon tax
• Carbon trading
• Pigou Club
• Fat tax
• Soda tax

Further reading

• Mankiw, N. Gregory (2001), Principles of Economics (Second ed.), Fort Worth: Harcourt College Publishers, p. 216, ISBN 0030259517.
• Pigou, A.C. "II, Chapter IX: Divergences Between Marginal Social Net Product and Marginal Private Net Product" in The Economics of Welfare (1932)

External links

• Cheap Gas Hurts (from a welfare analysis perspective) from Aplia Econ Blog