A
Pigovian tax is a
taxTo tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
levied on a market activity that generates
negative externalitiesIn economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
. The tax is intended to correct the
market outcomeIn economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...
. In the presence of negative externalities, the
social costSocial cost, in economics, is generally defined in opposition to "private cost". In economics, theorists model individual decision-making as measurement of costs and benefits...
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
economistAn economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...
Arthur Pigou who also developed the concept of
economic externalitiesIn economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
.
William BaumolWilliam Jack Baumol is an American economist. He is a professor of economics at New York University and is also affiliated with Princeton University. Baumol has written extensively about labor market and other economic factors that affect the economy. He also made valuable contributions to the...
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.
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 HayekFriedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
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 theoryChaos theory is a field of study in mathematics, with applications in several disciplines including physics, economics, biology, and philosophy. Chaos theory studies the behavior of dynamical systems that are highly sensitive to initial conditions, an effect which is popularly referred to as the...
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
smugglingSmuggling is the clandestine transportation of goods or persons, such as out of a building, into a prison, or across an international border, in violation of applicable laws or other regulations.There are various motivations to smuggle...
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
regressiveA regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. "Regressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, where the average tax rate exceeds the...
.
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-efficientPareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...
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
spilloverKnowledge spillover is an exchange of ideas among individuals. In knowledge management economics, a knowledge spillover is a non-rival knowledge market externality that has a spillover effect of stimulating technological improvements in a neighbor through one's own innovation...
(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 drugsThe prohibition of drugs through sumptuary legislation or religious law is a common means of attempting to prevent drug use. Prohibition of drugs has existed at various levels of government or other authority from the Middle Ages to the present....
. 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.
Direct regulation
Governments can choose to directly regulate the amount of a negative externality. However this sort of direct
regulationRegulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...
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
pollutionPollution is the introduction of contaminants into a natural environment that causes instability, disorder, harm or discomfort to the ecosystem i.e. physical systems or living organisms. Pollution can take the form of chemical substances or energy, such as noise, heat or light...
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 IndicatorThe genuine progress indicator is an alternative metric system which is an addition to the national system of accounts that has been suggested to replace, or supplement, gross domestic product as a metric of economic growth...
and other human economic indicators, as well as higher
gross domestic productGross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
(GDP) growth.
Pigouvian taxation may result 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. However, the gain to tax revenue (the "revenue-recycling effect) may be partly, fully, or more than fully offset by the interactions of the Pigouvian tax on the income tax. Since the Pigouvian tax will tend to increase the price of the externality-producing good and thus reduce the real return to working (and so potentially reducing revenues from the income tax), many economists have become somewhat skeptical of the "double dividend".
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 taxEcotax refers to taxes intended to promote ecologically sustainable activities via economic incentives. Such a policy can complement or avert the need for regulatory approaches. Often, an ecotax policy proposal may attempt to maintain overall tax revenue by proportionately reducing other taxes...
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
NorwayNorway , officially the Kingdom of Norway, is a Nordic unitary constitutional monarchy whose territory comprises the western portion of the Scandinavian Peninsula, Jan Mayen, and the Arctic archipelago of Svalbard and Bouvet Island. Norway has a total area of and a population of about 4.9 million...
,
SwedenSweden , officially the Kingdom of Sweden , is a Nordic country on the Scandinavian Peninsula in Northern Europe. Sweden borders with Norway and Finland and is connected to Denmark by a bridge-tunnel across the Öresund....
and
NetherlandsThe Netherlands is a constituent country of the Kingdom of the Netherlands, located mainly in North-West Europe and with several islands in the Caribbean. Mainland Netherlands borders the North Sea to the north and west, Belgium to the south, and Germany to the east, and shares maritime borders...
experience higher GDP growth and higher HDI growth rate. However, these studies only show a
correlationIn statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
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 tradingEmissions trading is a market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants....
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 EconomicsEnvironmental economics is a subfield of economics concerned with environmental issues. Quoting from the National Bureau of Economic Research Environmental Economics program:...
generally, and
Free-market environmentalismFree-market environmentalism is a position that argues that the free market, property rights, and tort law provide the best tools to preserve the health and sustainability of the environment...
specifically.
See also
- Social cost
- Carbon tax
A carbon tax is an environmental tax levied on the carbon content of fuels. It is a form of carbon pricing. Carbon is present in every hydrocarbon fuel and is released as carbon dioxide when they are burnt. In contrast, non-combustion energy sources—wind, sunlight, hydropower, and nuclear—do not...
- Carbon trading
Carbon trading may refer to:*Carbon emission trading*Personal carbon trading*Emissions trading...
- Pigou Club
The Pigou Club is described by its inventor, economist N. Gregory Mankiw, as "an elite group of economists and pundits who have publicly advocated higher Pigovian taxes, such as gasoline taxes or carbon taxes." Typically, these pundits and economists also advocate lowering other taxes, such as the...
- Fat tax
A fat tax is a tax or surcharge that is placed upon fattening foods, beverages or individuals. As an example of Pigovian taxation, a fat tax aims to discourage unhealthy diets and offset the economic costs of obesity....
- Soda tax
A soda tax or soft drink tax is a tax or surcharge on soft drinks. It may focus on sugar-sweetened beverages ....
Further reading
.
External links
- Cheap Gas Hurts (from a welfare analysis perspective) from Aplia
Aplia Inc. is an educational technology company founded in 2000 by Stanford University professor Paul Romer that offers online homework products geared toward college-level courses. In March 2007 Cengage Learning acquired Aplia Inc...
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