Pigovian tax

A Pigovian tax (also spelled Pigouvian tax) is a tax levied on a non-market activity that generates
negative externalities; such a 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 the result may lead to over-consumption of the
product. A Pigovian tax equal to the negative externality is thought to correct the market outcome.

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

A Pigovian tax is considered one of the "traditional" means of bringing a modicum of market forces, and
thus better market efficiency, to economic situations where externality
problems exist. More recently, particularly in the United States since the
late 1970s, and in other developed nations since the 1980s, an
alternative to Pigovian taxation has arisen: the creation of a market for
"pollution rights." Pollution rights markets are not generally more
efficient than Pigovian taxes but are often more appealing to policy
makers because 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.

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.

A counter-argument is that perfect knowledge of the gaps between private and public costs is not
necessary: So long as a tax level reflects a negative externality better than no tax, it should increase
efficiency. Sometimes these differences are obvious – for example the effect of petroleum use on
pollution, global warming and traffic congestion. In such a case, the levying of a Pigovian tax
approximating such costs would be better than no tax at all.

Aside from efficiency, Pigovian taxes may increase the equity or 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. 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.

Pollution taxes

The alternative, regulation, is viewed as having a higher cost to society because Pigovian taxes raise
revenue and respond automatically to changes in the market such as lowered cost of production or
pollution mitigation. 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.

Economic theory predicts that, under certain conditions, a double dividend could appear. The first is the
reduction of pollution. The second consists in the recycling of the government revenue from the green
tax. If the government keeps its revenue constant, some other taxes have to be cut (see Green tax shift).
If the government chooses to cut distortional taxes, the costs of the swap to green taxes would be
negative.

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.

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.