Pigovian Tax: Definition, Purpose, Calculation, and Examples

What Is a Pigovian Tax?

A Pigovian (also spelled Pigouvian) tax is a tax assessed against private individuals or businesses for engaging in activities that create adverse side effects for society. Adverse side effects are those costs that are not included as a part of the product's market price. These include environmental pollution, strains on public healthcare from the sale of tobacco products, and any other side effects that have an external, negative impact.

Pigovian taxes were named after English economist, Arthur Pigou, a significant contributor to early externality theory.

Understanding a Pigovian Tax

The Pigovian tax is meant to discourage activities that impose a 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 take on all costs of production. This adverse effect might be corrected, he suggested, by levying taxes equal to the externalized costs. Ideally, the tax would be equivalent to the external damage caused by the producer and thereby reduce the external costs going forward.

Negative externalities are not necessarily “bad.” Instead, a negative externality occurs whenever an economic entity does not fully internalize the costs of its 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 impacted third parties bear part of the cost of pollution. This cost might manifest through contaminated property or health risks. The polluter only takes into consideration the private costs, not the external costs.

Once Pigou factored in external costs to society, the economy suffered deadweight loss from excess pollution beyond the “socially optimal” level. Pigou believed that state intervention should correct negative externalities, which he considered a market failure. He suggested that this be accomplished through taxation.

Advantages and Disadvantages of a Pigovian Tax

Advantages

Economists favor Pigouvian taxes because they tend to correct for negative externalities, which are generally a burden on the public. For example, air pollution from a factory is borne out in health issues like lung cancer among the population. If the polluter were forced to pay a tax, it would not only help offset the economic cost of such illnesses, it would discourage the factory from polluting so much in the first place. This means that Pigouvian taxes benefit society and tend to improve social welfare, so long as they are properly applied.

Disadvantages

Pigou’s externality theories were dominant in mainstream economics for 40 years but lost favor after Nobel Prize-winner, Ronald Coase, presented his ideas. Using Pigou’s analytical framework, Coase demonstrated that Pigou’s examination and solution were often wrong, for at least three separate reasons:

1. 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. The critical element is transaction cost theory, not externality theory.

Pigovian taxes also encounter what Austrian economist Ludwig von Mises first described as “calculation and knowledge problems.” A government cannot issue the correct Pigovian tax without knowing in advance what the most efficient outcome is. This would require knowing the precise amount of the externality cost imposed by the producer, as well as the correct price and output for the specific market. If lawmakers overestimate the external costs involved, Pigovian taxes cause more harm than good.

Examples of a Pigovian Tax

Despite any counterarguments towards Pigou's theories, Pigovian taxes are prevalent in society today. One of the most popular Pigovian taxes is a carbon emissions tax. Governments impose a carbon emissions tax on any company that burns fossil fuels. When burned, fossil fuels emit greenhouse gases, the cause of global warming, which is damaging our planet in a multitude of ways.

The carbon tax is intended to factor in the real cost of burning fossil fuels, which is paid by society. The end role of the carbon tax is to ensure that the producers of carbon products are the ones incurring this external cost.

Another Pigovian tax, common in Europe, is a tax on plastic bags, and sometimes even paper bags. This encourages consumers to bring their own reusable bags from home to deter the use of plastic and paper. Plastic is a by-product of burning fossil fuels and results in the damage to marine life, while paper bags encourage deforestation. By charging even a small amount, like a few cents per bag, it encourages shoppers to bring along their own reusable bags.

Taxes on "sin" items like alcohol and cigarettes can be construed as a Pigovian tax. This is because they discourage behavior that not can harm an individual user, but also has knock-on effects for others. Second-hand smoke is an obvious example, but so too is the healthcare burden of smokers who become ill with cancer or emphysema. Alcohol is responsible for drunk driving accidents, including injuries and deaths among innocent others.

All of the above cases cite negative externalities, whose price does not take into consideration the cost to society. The implemented taxes are a measure to redistribute those costs back to the producer or user that generates the negative externality.