Pigovian Tax Definition

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Pigovian Tax Definition

What Is a Pigovian Tax?

A Pigovian (sometimes called Pigouvian) tax is a levy levied on private people or companies for participating in activities that have negative societal consequences. Adverse side effects are expenses that are not accounted for in the product’s market price. These include environmental pollution, stress on public healthcare caused by the selling of tobacco products, and any other unintended consequences.

Pigovian taxes were named after Arthur Pigou, an English economist who contributed significantly to early externality theory.

Key Takeaways

  • A Pigovian tax is designed to charge the producer of commodities or services that have negative societal consequences.
  • Economists contend that the costs of negative externalities, such as pollution, are absorbed by society rather than the producer.
  • The Pigovian tax’s goal is to transfer the cost of the negative externality back to the producer or consumer.
  • Pigovian tariffs include a tax on carbon emissions and a levy on plastic bags.
  • Pigovian taxes are intended to match the cost of a negative externality, but they may be difficult to calculate and, if overstated, can be harmful to society.

Understanding a Pigovian Tax

The Pigoviantax is intended to deter behaviors that shift production costs to third parties and society as a whole. Negative externalities, according to Pigou, prohibit a market economy from attaining equilibrium when producers do not bear all costs of production. He proposed that this negative impact be mitigated by levying taxes proportional to the externalized expenses. Ideally, the tax would be equal to the external harm created by the producer, reducing future external expenses.

Negative externalities are not always “bad.” A negative externality develops instead when an economic entity fails to completely absorb the costs of its activity. In such cases, society, including the environment, suffers the majority of the expenses of economic activity.

A pollution tax is a common example of a Pigovian-style tax. Because harmed third parties suffer a portion of the cost of pollution, pollution from a manufacturing causes a negative externality. This cost might be shown as polluted property or health problems. The polluter considers just the private expenses, not the external costs.

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Pigou calculated that excess pollution over the “socially optimum” threshold resulted in deadweight loss for the economy. Pigou felt that government intervention should be used to address negative externalities, which he saw as a market failure. He proposed that this be done via taxes.

Advantages and Disadvantages of a Pigovian Tax

Advantages

Pigouvian taxes are preferred by economists because they tend to adjust for negative externalities, which are typically a burden on the public. For example, air pollution from a factory causes health problems such as lung cancer in the community. If the polluter was obliged to pay a fee, it would not only assist balance the economic cost of such diseases, but it would also deter the firm from polluting in the first place. This suggests that Pigouvian taxes benefit society and tend to promote social welfare when used correctly.

Disadvantages

For 40 years, Pigou’s externality theories dominated mainstream economics, but they fell out of favor once Nobel laureate Ronald Coase presented his views. Coase proved, using Pigou’s analytical framework, that Pigou’s investigation and solution were often incorrect, for at least three distinct reasons:

  1. Negative externalities did not always result in inefficiency.
  2. Pigovian taxes, even though inefficient, did not produce an efficient outcome.
  3. Transaction cost theory, not externality theory, is crucial.

Pigovian taxes also face “calculation and knowledge issues,” as Austrian economist Ludwig von Mises initially characterized them. A government cannot levy the right Pigovian tax unless it first determines the most efficient result. This would need knowing the exact amount of the producer’s externality cost, as well as the proper price and production for the given market. Pigovian taxes create more damage than benefit if politicians overestimate the external expenses involved.

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Pigouvian Tax Pros and Cons

Cons
  • Pigouvian taxes are difficult to calculate properly

  • Imposing the wrong tax would be inefficient and costly

  • Can unequally impose higher costs on lower-income areas

Examples of a Pigovian Tax

Pigovian taxes are still in use today, notwithstanding any criticisms of Pigou’s views. A carbon emissions tax is one of the most common Pigovian taxes. Governments levy a carbon tax on every enterprise that uses fossil fuels. When fossil fuels are used, they release greenhouse gases, which contribute to global warming and harm our world in a variety of ways.

The carbon tax is meant to account for the true cost of using fossil fuels, which is borne by society. The carbon tax’s ultimate goal is to guarantee that the producers of carbon goods bear this external cost.

A tax on plastic bags, and occasionally even paper bags, is another Pigovian tax that is popular throughout Europe. To reduce the use of plastic and paper, this encourages customers to bring their own reusable bags from home. Plastic is a byproduct of fossil fuel combustion that harms marine life, while paper bags promote deforestation. It encourages buyers to bring their own reusable bags by charging even a modest fee, such as a few cents per bag.

Pigovian taxes may be imposed on “sin” commodities such as alcohol and cigarettes. This is because they prohibit conduct that not only harms the individual user but also has a negative impact on others. Secondhand smoking is a clear example, but so is the healthcare cost borne by smokers who develop cancer or emphysema. Drunk driving accidents, involving injuries and fatalities to others, are caused by alcohol.

All of the above examples include negative externalities, the price of which does not include the cost to society. The imposed taxes are a method of redistributing costs back to the producer or user who causes the negative externality.

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Gasoline taxes are Pigouvian in nature because they discourage needless driving and the profits are utilized to construct, maintain, and modernize transportation infrastructure that benefits society. In the United States, each state has its own gas tax, while the federal government adds an extra 18.3 cents per gallon for unleaded gasoline (24.3 cents for diesel).

What Is a Negative Externality?

In economics, a negative externality is a byproduct generated by any person, business, or industry that has a detrimental influence on society but is not paid for by the entity that created it. Instead, society bears the cost. Among the many examples are air and noise pollution, toxic runoff, and the unintentional death of pollinators by pesticides.

What Is the Difference Between a Pigovian Tax and a Sin Tax?

Pigouvian taxes and sin taxes are quite similar, and a single charge may satisfy both. The main distinction is that a Pigouvian tax attempts to decrease negative externalities (harms to others or society as a whole), while sin taxes strive to lessen negative internalities (i.e., harms to oneself).There are possible harmful internalities and externalities in the case of cigarettes and alcohol, for example.

How Do You Calculate a Pigovian Tax?

A Pigouvian tax is notoriously difficult to calculate correctly. In principle, the tax should be precisely equal to the net cost of the externality being addressed. At a given level of output, the tax would thus be equal to the difference between the societal cost and the marginal private cost.

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