Pigouvian Tax

What is a Pigouvian Tax?

A Pigouvian tax, named after 1920 British economist Arthur C. Pigou, is a tax on a market transaction that creates a negative externality, or an additional cost, borne by individuals not directly involved in the transaction. Examples include tobacco taxes, sugar taxes, and carbon taxes. 

How Does a Pigouvian Tax Differ from a Pigouvian Subsidy?

In contrast, a Pigouvian subsidy is a government benefit targeted towards encouraging transactions that are seen to have a positive benefit to society that cannot be paid for by the third parties who indirectly benefit from the transaction. Examples of Pigouvian subsidies are public funding for education and for vaccination.

What Is the Impact of a Pigouvian Tax?

An externality, in economics terms, is a side effect or consequence of an economic transaction or activity that is not reflected in the cost of said transaction or activity and not primarily borne by those directly involved in the transaction or activity.

For instance, smoking in a public restaurant creates a negative externality because secondhand smoke can affect nonsmokers and worsen their long-term health outcomes. Drivers of gas-powered vehicles pay the gas tax to account for the externalities of pollution and wear and tear to the roads. Levying an excise tax in these situations can serve to recoup some of the cost of these externalities and “internalize” the cost of the externality to the purchase of the product. Sin taxes in general are also used to discourage consumption and “price-in” the externalities of products such as gambling, alcohol, and tobacco.

The Pigouvian concept of internalizing externalities in order to correct inefficient market outcomes suggests that the size of the excise tax should be equal to the cost of the negative externality.

However, there are several challenges to imposing excise taxes in response to negative externalities: There is usually no way to accurately measure the societal cost or externality.

  • It is difficult to measure the effectiveness of public policies in deterring or reducing externalities.
  • Fully efficient taxes that endeavor to recover external social costs may vary by location and person; a theoretically correct tax would need to vary according to these differences.

What Is an Example of a Pigouvian Tax?

When individuals purchase goods created through a carbon-intensive production process, they create a negative externality under the assumption that excess carbon emissions are harmful for the environment. This negative externality imposes an indirect cost upon those who were not part of the initial transaction of production and purchase. Proponents of a carbon tax argue that such a tax internalizes these external costs on the environment by adding them to the price of the good.

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