A Pigovian (Pigouvian) tax is liquid waste, or effluent, a fee which is assessed against private individuals or businesses for engaging in activities that create adverse side effects. Adverse side effects are those costs which are not included as a part of the product's market price. 

Pigovian taxes were named after English economist Arthur C. Pigou, a significant contributor to early externality theory in the Cambridge tradition.

Breaking Down Pigovian Tax

The Pigovian tax is meant to discourage activities that impose a net cost of production onto third parties and society as a whole. According to Pigou, negative externalities prevent a market economy from reaching equilibrium when producers do not internalize all costs of production. This adverse effect might be corrected, he contended, by levying taxes equal to the externalized costs.

Negative Externalities and Social Costs

Negative externalities are not necessarily “bad” in the normative sense. Instead, a negative externality occurs whenever an economic entity does not fully internalize the costs of their activity. In these situations, society, including the environment, bears most of the costs of economic activity.

A popular example of a Pigovian-style tax is a tax on pollution. Pollution from a factory creates a negative externality because nearby or impacted third parties bear part of the cost of pollution. This cost might manifest through dirtied property or health risks. The polluter only internalizes the marginal private costs, not the marginal external costs. Once Pigou added in the external costs and created what he called marginal social cost, the economy suffered deadweight loss from excess pollution beyond the “socially optimal” level.

A.C. Pigou popularized the concept of a Pigovian tax in his influential book “The Economics of Welfare” (1920). Building on Alfred Marshall’s analysis of markets, Pigou believed state intervention should correct negative externalities, which he considered a market failure. This is accomplished, Pigou contended, through scientifically measured and selective taxation.

To arrive at the social optimal tax, the government regulator must estimate the marginal social cost and marginal private cost, extrapolating from those the deadweight loss to the economy.

Pigou’s externality theories were dominant in mainstream economics for 40 years but lost favor after Nobel Prize-winner Ronald Coase published “The Problem of Social Cost” (1960). Using Pigou’s analytical framework, Coase demonstrated that Pigou’s examination and solution were often wrong, for at least three separate reasons. 

  1. Coase showed negative externalities did not necessarily lead to an inefficient result.
  2. Even if they were inefficient, Pigovian taxes did not tend to lead to an efficient result.
  3. Coase argued the critical element was transaction cost theory, not externality theory.

Calculation and Knowledge Problems

Pigovian taxes encounter what Austrian economist Ludwig von Mises first described as “calculation and knowledge problems” in his “Economic Calculation in the Socialist Commonwealth” (1920). A government regulator cannot issue the correct, social optimal Pigovian tax without knowing in advance what the most efficient outcome is.

This would require knowing the precise amount of externality cost imposed by the polluter, as well as the correct price and output for the specific market and all associated goods and services. If lawmakers overestimate the external costs involved, Pigovian taxes cause more harm than good.