Pigouvian Taxes

Introduction

In economics externalities are the effects of one’s action on third parties. An externality can be positive or negative, and in general the occurrence of externalities is unintended. Negative externalities are those effects which cause harm upon (non-consenting) third parties.

Because of the harm principle the government is justified to create regulation to reduce the amount of negative externalities. There are several ways to do so. First the government can prohibit or restrict certain activities. Secondly the government can discourage certain activities.

Pigouvian tax

One method to discourage certain activities is to impose a tax on such activities. The idea is that by making undesirable activities more expensive, people will either limit such activities or to abstain completely from it.

The first question is how much tax should be levied. There are several things to be considered: the cost of enforcement, the effective deterrent and the compensation of harm caused.

Every tax has to be enforced, and tax enforcement is not for free. Ideally the revenues of a tax should be larger than the costs to collect it. Once we know what it takes to enforce a pigouvian tax, we could determine the minimal tax liability.

A possible problem, however, might be that this minimal liability, does not actually deter people from performing undesirable activities. This because the benefits they can gain, outweigh their tax liabilities. Hence the tax should be large enough to cancel any net benefit. On the other hand, this second minimum could be lower than the costs of enforcement.

Another way to look at the height of tax liability, is to take the cost of compensating negative externalities into account. For instance if water wells have been polluted, there are costs involved in restoring the water wells. On the maxim “the polluter will pay”, it’s reasonable to charge those who have polluted with this costs.

On the other hand, pigouvian taxes are meant to prevent the occurrence of negative externalities. Economically, the costs saved by this prevention should be counted as a benefit. Consequently, it does not actually matter if the revenues raised by a pigouvian tax does not cover the costs of its enforcement, as long as this tax succeed in reducing negative externalities.

Also the success of a pigouvian tax should not be measured in terms of revenues generated, but in terms of harm reduced. In a best case scenario a pigouvian tax will generate zero revenue, because everyone quits producing negative externalities. A pigouvian tax should not be imposed solely for the purpose of raising public revenue. Nevertheless the revenues raised in this way, should be used for public causes.

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11 thoughts on “Pigouvian Taxes”

  1. Good policy, but sadly, its a human flaw (presently, at least) that if you tax something which you’d like to discourage, it’ll only open a black market for the product or service.

    1. True, and that’s why enforcement costs are never zero. On the other hand taxing something is often a better alternative than outright prohibition, because complete illegality would push everyone involved into black markets.

  2. What if instead of penalty, there was a reward system for those who did good? Would this be more attractive to most people? Levying a tax sometimes becomes counterproductive especially if the group affected can still afford it. They would adjust their lifestyle to allow for the tax

    1. >>What if instead of penalty, there was a reward system for those who did good?

      Originally I wanted to call this post “Pigouvian taxes & subsidies”. A pigouvian subsidy would be a reward for producing positive externalities.

      >>Levying a tax sometimes becomes counterproductive especially if the group affected can still afford it.

      No doubt about this. But the purpose of this post is not proving that taxes are the best solutions. Tax is just one tool among others, we should decide what tool we’ll use on a case by case base.

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