Pigovian Tax DEFINITION OF 'PIGOVIAN TAX'A special tax that is often levied on companies that pollute the environment or create excess social costs, called negative externalities, through business practices. In a true market economy, a Pigovian tax is the most efficient and effective way to correct negative externalities.

A type of a Pigovian tax is a "sin tax", which is a special tax on tobacco products and alcohol.

INVESTOPEDIA EXPLAINS 'PIGOVIAN TAX'Pigovian tax is applicable only because market economies often fail to provide a proper incentive to reduce negative externalities. For example, a coal-powered plant may be polluting a nearby river by disposing its harmful byproducts in the river instead of shipping the byproducts to a special facility. A sufficient Pigovian tax would punish this firm economically when it chooses to dispose of the harmful byproducts in the river, creating an incentive to use more environmentally friendly methods of disposal.

Pigouvian TaxBy Nicole and Chris 2. What Is Pigouvian Tax?• A tax that is used to reduce negative

externalities.• For example a tax applied to carbon emissions to encourage entities to reduce their carbon foot print.

3. Pigouvian Tax Implementations in New Zealand• We have seen taxes introduce to cigarettes, alcohol, fossil fuels and carbon emissions via the emissions trading scheme

4. How Pigouvian Tax Works• Pigouvian tax system works by taxing users according to their consumption.• The more you use the more you pay in tax.• This then encourages a reduction in the product use.

5. What are the advantages of this form of Tax?• A reduction in negative externalities• Money can be put back into the community and the environment• Taxes the ‘rich’ though this could be seen as a disadvantage as well

6. What are the disadvantages of this form tax?• More burdens for businesses• Doesn’t set a standard for businesses to reach.• Cost

Implementation• Doesn’t stop people from using the products that cause negative externalities.

7. In summary• Pigouvian Tax is used world wide because of its effectiveness.• Its effectiveness allows governments to put money back into the community, environment and provide essential infrastructure.• Most importantly a reduction in negative externalities

NO one enjoys paying taxes — and no politician relishes raising them. Yet some taxes actually make us better off, even apart from the revenue they provide for public services.Taxes on activities with harmful side effects are a case in point. Strongly favored even by many conservative Republican economists, these levies are known as Pigovian taxes, after the British economist Arthur C. Pigou, who advocated them in his 1920 book, “The Economics of Welfare.” In today’s deeply polarized political climate, they offer one of the few realistic hopes for progress.

To see how Pigovian taxes work, consider a driver checking out the offerings at his local auto dealership. He is trying to decide between two vehicles, one weighing 6,000 pounds and the other, 4,000 pounds. After comparing sticker prices, mileage estimates and other features, he views the choice as roughly a tossup. But because he has a slight preference for the larger vehicle, he buys it. His decision, however, could be viewed as a bad choice for society as a whole, because of the side effects. The laws of physics tell us that heavier vehicles tend to cause more damage in crashes. They also spew more emissions into the air and cause more wear and tear on roads.

By providing an incentive to take those external costs into account, taxing vehicles by weight would make the total economic pie larger. Those who don’t really need heavier vehicles could buy lighter ones and pay less tax. Others could pay the extra tax as fair compensation for their heavier vehicles’ negative side effects.

But the mere fact that Pigovian taxes produce greater benefits than costs doesn’t make them an easy sell politically. Like other changes in public policy, a Pigovian tax produces winners and losers. And it’s an iron law of politics that prospective losers lobby harder to block change than prospective winners do for its adoption. That asymmetry creates a powerful status-quo bias that makes even broadly beneficial policy changes hard to achieve.

Yet, in principle, any change that makes the economic pie larger makes it possible for everyone to enjoy a bigger slice than before. The practical challenge is to slice the larger pie so that everyone comes out ahead. A first step toward a vehicle-weight tax would be to make it revenue-neutral — for example, by returning its revenue in the form of lump-sum rebates to each buyer. That would soften the blow, while preserving the incentive to buy lighter vehicles.

For example, if the tax were 20 cents a pound, a 6,000-pound vehicle would be taxed at $1,200, as opposed to $800 for a 4,000-pound one. If an equal number of vehicles of each weight were sold, all buyers would get a $1,000 rebate when the total tax income was redistributed. The buyer in our example would thus be making a net payment of $200 because of the tax, but his total outlay would have been $400 lower if he’d bought the smaller vehicle instead.

Although revenue neutrality would help, buyers who really need large vehicles might feel aggrieved. Paradoxically, the key to mollifying them is to propose Pigovian taxes not just on vehicle weight but also on a swath of other activities that cause undue harm to others. We could tax drivers contributing to traffic congestion, for example, on the grounds that entering a crowded roadway causes delays to others. We could tax noise, carbon emissions and other specific forms of air and water pollution. Although some people would end up as losers under any single one of these measures, virtually everyone would come out ahead under a broad suite of Pigovian taxes.

That’s because adopting a large number of them is like repeated flips of a coin whose odds are stacked heavily in your favor. If someone offered a chance to flip a coin that paid $10 for heads and lost $1 for tails, would you take it? It’s an attractive gamble, obviously, but if there is only a single flip, there’s a 50 percent chance that you’ll be a loser. After many flips, however, you’d almost certainly be a net winner.

Likewise, any single Pigovian tax is an attractive gamble for the average taxpayer, who would get a rebate equal to the amount she’d paid in tax and would benefit from the resulting reduction in harm. Under a collection of such taxes, the odds of being a net winner go up sharply. Only the minuscule minority who cause much more than average amounts of harm in almost every category might end up paying more total tax than before. And even those few would still be net winners, because of the corresponding reductions in harm.

A BROAD slate of Pigovian taxes would thus meet the challenge of how to divide the larger pie so everyone comes out ahead. And because the prospect of a continued divided government makes short-run legislative progress unlikely on other fronts, why not pick this low-hanging fruit right now?

The case for Pigovian taxes isn’t easily reduced to bumper-sticker slogans. Still, the basic ideas are not complicated, and President Obama has the biggest megaphone on the planet. It should be easy for him to persuade rational voters to embrace policies that would make virtually everyone better off.

But he must also persuade House Republicans. Getting their votes will be the real test of his celebrated rhetorical skills.

Arthur Cecil Pigou (1877–1959) proposed a solution to the problem of externalities that has become a standard approach. This simple idea is to impose a per-unit tax on a good, thereby generating negative externalities equal to the marginal externality at the socially efficient quantity. This is known as a Pigouvian tax. Thus, if at the socially efficient quantity, the marginal external cost is $1, then a $1 per-unit tax would lead to the right outcome. This is illustrated in Figure 7.3 "The Pigouvian tax".The tax that is added is the difference, at the socially efficient quantity, between the marginal social cost and the marginal private cost, which equals the marginal external cost. The tax level need not equal the marginal external cost at other quantities, and the figure reflects a marginal external cost that is growing as the quantity grows. Nevertheless, the new supply curve created by the addition of the tax intersects demand (the marginal benefit) at the socially efficient quantity. As a result, the new competitive equilibrium, taking account of the tax, is efficient.

The case of a positive externality is similar. Here, a subsidy is needed to induce the efficient quantity. It is left as an exercise.

Figure 7.3 The Pigouvian tax

Taxes and subsidies are fairly common instruments to control externalities. We subsidize higher education with state universities, and the federal government provides funds for research and limited funds for the arts. Taxes on cigarettes and alcoholic beverages are used to discourage these activities, perhaps because smoking and drinking alcoholic beverages create negative externalities. (Cigarettes and alcohol also have inelastic demands, which make them good candidates for taxation since there is only a small distortion of the quantity.) However, while important in some arenas, taxes and subsidies are not the most common approach to regulation of externalities.

KEY TAKEAWAYS A Pigouvian tax is a per-unit tax on a good, thereby generating negative

externalities equal to the marginal externality at the socially efficient quantity.

Imposition of a Pigouvian tax leads to a competitive equilibrium, taking account of the tax, which is efficient.

In the case of a positive externality, a subsidy can be used to obtain efficiency.

Taxes and subsidies are fairly common instruments to control externalities.

A Pigovian tax (also spelled Pigouvian tax) is a tax applied to a market activity that is generating negative externalities (costs for somebody else). The tax is intended to correct an inefficient market outcome, and does so by being set equal to the negative externalities. In the

presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product.[1] An often-cited example of such an externality is environmental pollution.[2]

In the presence of positive externalities, i.e., public benefits from a market activity, those who receive the benefit do not pay for it and the market may under-supply the product. Similar logic suggests the creation of a Pigovian subsidy to make the users pay for the extra benefit and spur more production.[3] An example sometimes cited is a subsidy for provision of flu vaccine.[4]

Pigovian taxes are named after economist Arthur Pigou who also developed the concept of economic externalities. William Baumolwas instrumental in framing Pigou's work in modern economics.

What Is Pigovian Tax Economics Essay

Neo-classicals uphold perfect competition as the ideal state of the market. But in truth, the economy is fraught with market failures. Therefore, we need government interference to correct many of these market failures. Pigovian Tax imposed by the government is one such course of intervention. It helps to curb negative externalities (e.g. pollution) and reduce the burden on the society caused by the externalities (social costs of production and consumption). Moreover, it attacks over-consumption, bringing it closer to the socially optimal level of production and/or consumption. The paper examines the effects of Pigovian tax and analyses its degree of effectiveness on an economy.

What is Pigovian Tax?

Pigovian tax is a kind of tax, which is levied to correct a negative cost that is created by the actions of any business firm, but that is not considered in a firm’s private costs or profits. Also known as ‘sin tax’, it is a tax placed on an action with a negative externality, to correct market failure (Mankiw, 2010). In the presence of negative externalities, the social cost  of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient  and

may lead to over-consumption of the product. A Pigovian tax equal to the negative externality is thought to correct the market outcome back to the level of efficiency.

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For example, a factory does not financially take into consideration the damages caused to the environment by their emissions. By imposing Pigovian Tax, the government can artificially make the firms bear the cost of the damages, which will ideally be equal to what the price would have been if a market for such an activity existed. In a country like Canada with a publicly funded health care system, that is, where the medical service of every patient is funded from government revenues, the cigarette tax acts as a Pigovian tax - it raises the revenue necessary to offset the expenses towards the health care system, as a consequence of smoking.

Pigovian Tax in Implementation

This idea was first put forward by Arthur Cecil Pigou in the year 1912. In his book, The Economics of Welfare, he argued that industrialists seek their own marginal private interest, while not taking into account the social costs of their activities. Diagram 1 depicts how a tax can cover the social cost of a negative externality.

Diagram 1- Pigovian Tax

Pigovian tax is the difference between marginal social cost and the marginal private cost, which is equal to the marginal external cost, shown as Tax in the diagram. The tax level may not equal the marginal external cost at quantities other than the socially optimum equilibrium level. The diagram indicates that marginal external cost increases with increase in quantity produced or consumed. After imposition of the Pigovian Tax, the new supply curve intersects demand (the marginal benefit) at the socially efficient quantity. As a result, the new competitive equilibrium, taking into account the amount of the tax, is efficient. Although this tax works perfectly in theory, its practical implementation is very difficult due to a lack of complete information on the cost of the damages to the environment.

When Arthur Pigou first came up with the concept, he laid down a set of assumptions, one of which is a perfectly competitive market. Yet, perfect competition is an unrealistic situation. Monopoly, monopsony and oligopoly markets are commonplace. To internalize the external cost, the government needs to intervene by way of imposing taxes.

Pigovian tax can be applied to all spheres of production, be it production of a good (automobile) or service (transportation, banking etc). Baumol and Oates (1975) argue that if Pigovian tax is set equal to the level of marginal damage (external cost) at the Pareto-optimal level of pollution, the industry will move towards its optimal pollution level.

Diagram 2: Pigovian Tax produced on A Good with a Negative Externality

The tax is applied to the production of a good that has an externality.

Overhead: Pigovian Tax Anatomy from Diagram 2-

i. Unregulated result (Q, P)

ii. Socially efficient level of production = Q’

iii. Efficient Pigovian tax = P’-P’’

iv. Tax payment to government (shared by consumer and producers = P’ACP”

v. Gross benefit from decrease in externality = ADBC

vi. Foregone consumption benefits – i.e., the social cost of abatement = ABC

vii. Net benefit to society = ADB

Pigovian tax enhances welfare of the society; restricting over-consumption. It also generates additional revenue for the government. Roland Coase (1960) propounded that if markets may not secure the optimal amount of externality, they “can be very gently ‘nudged’ in that direction without the necessity for full-scale regulatory activity”. Yet again, the coarse theorem faces criticism. Property rights are not as strictly defined as required by the coarse theorem. Coarse argued that social costs are even worse if only the offender pays for the social harm and not the consumers for whom the goods and services are produced. Under the Pigovian Tax, it is only the firms who pay for the externalities. Moreover, it is difficult to calculate the right tax in a world of imperfect Coarsian bargains.

The concept has evolved through time and many similar ideas were developed such as the Coarse theorem, emission trading i.e. cap and trade (Europe),

Environmental Protection agencies (U.S.) formed with the idea of command and control, carbon tax, and tradable permits.

The principal problem remains that of quantifying the externality. “There is some debate about whether to quantify externalities if the methods are imperfect. The usual response is that as long as we are honest about the flaws in the numbers, it is better to have some numbers than none” (Phillips, Carl V, 1999). The benefits accrued by taxing externalities are more than that without taxing the externalities as shown with the game theory approach.

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The co-ordination game consists of two players, Company A and Company B, with two strategies: Subject to Pigovian Tax and Not Subject to Pigovian Tax. The payoffs of each player are given in the matrix. Nash equilibrium occurs at 2 points, when both companies are subject to Pigovian taxes and when both companies are not subject to Pigovian taxes.

Player B

Subject to Pigovian Tax

Not Subject to Pigovian Tax

Subject to Pigovian Tax

10, 10

4, 7

Not Subject to Pigovian Tax

7, 4

5, 5

Player A

If both the companies are ready to bear the social costs, the benefits of sustainability accrued to the companies and society as a whole are more than if the costs are not borne by either company.

The many forms of Pigovian Tax

Since players don’t always come to a socially efficient negotiation, there is a traditional way of limiting externalities - ‘command and control’. This approach sets quantity limits on activities that have external effects. However, the method is cumbersome. While this method has been undertaken by the US government, the economies of Europe consider cap and trade as a better solution. It causes the least polluting firms to do the majority of the production since their social cost of production is the lowest.

Rajeev K. Goel and Edward W. T. Hsieh laid down a two-period model in their research (Durable Emissions and Optimal Pigovian Taxes) where a social planner minimizes social damage by setting the per-unit Pigovian tax on a polluting monopolist. Results show that for a given level of production, the durability of emissions and the socially optimal Pigovian tax are negatively related. Mike Moffatt, in his article named ‘Pigovian Taxes - Joining the Pigou Club; Promoting Economic Growth and Reducing Externalities’, wrote in favor of Pigovian Tax, stating, ‘One of the uses of taxes is to discourage activity that has negative externalities, or we believe is otherwise economically/socially harmful.’

The benefits accrued versus the inherent failings

In addition to correcting social disequilibrium, these taxes also raise revenue for the state. In 2004-2005, the Canadian government collected $16.7 billion in "other" taxes, which were largely Pigovian taxes such as energy taxes and excise taxes on cigarettes and alcohol (Moffat, 2006).

In theory, using Pigovian taxes to correct what economists call “market failures” is simple. But in practice, it’s not so. The important problem often ignored by advocates of Pigovian taxes is what might be called the “measurement problem” or the “Knowledge Problem”. Pigou himself also declared that "it must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of [the gaps between private and public costs] could interfere with individual choice" (Pigou, 1954). Pigou and Friedrich Hayek point out that the assumption that the government can determine the marginal social cost of a negative externality and convert that amount into a monetary value is a key weakness in the framework of the Pigovian tax. The economist's blackboard "model" assumes knowledge we don't possess - it's a model with assumed "givens," which are in contrast with real-world happenings. Friedrich Hayek would argue that this is knowledge which could not be provided as a "given" by any "method", yet could be discovered, due to insuperable cognitive limits.

However, the key difficulty with this tax is calculating what level of applied tax would counterbalance the negative externalities. Even when a Pigovian tax is charged to correct the market imperfection in a world with regulations and efficient transfers, the observed amount of the externality (e.g., pollution) is unlikely to be zero since we will still observe some externalities as a consequence of the exchanges and transfers. The rate of tax best set should be equal to the per-unit external cost that “spills over” into the society. A tax imposed without such calculations may well be inefficient and redundant.

There is also political influence on the levied tax, in such a way that lobbying of government by the polluters may tend to reduce the level of the tax levied and which would ultimately reduce the mitigating effect of tax and lead to increase in production. Instead of accomplishing the goal of the tax imposed, the burden shifts to the society. Thomas A. Barthold (1994) argued that in the US in the year 1994, the actual policy decisions often came from budget requirements, and not concern for the environment. The taxes do not always comply with economic theory because social benefits and costs are hard to measure. He uses the 1989 Montreal Protocol as an example. President George H. W. Bush signed this protocol that allowed either a permit auction or a tax on ozone-depleting chemicals. Barthold attributes the decision to implement the tax to the pressure on the Ways and Means committee to come up with more consistent revenue.

Like the other taxes imposed by the government, Pigovian tax gives air to malpractices like black marketing, smuggling and child labour, especially if they create large differences in the prices of products, which are popular, and if the demand for the product increases in spite of the increase in production.

Pigovian Tax imposed by the government is a complex mechanism. It has its societal merits and elementary de-merits. While it covers the cost of negative externalities and eliminates the burden of society, on the same page, it may also

hamper the growth of industries leading to inefficiency of small industries. In a monopsony market, where there is only one buyer, it is difficult to impose Pigovian tax since the burden of the tax will be borne by one entity. This may consequently lead to rise in the prices of the commodity. When Pigovian tax is imposed, in a monopolistic competitive market, the tax will be borne by a large number of consumers and hence, the burden of tax is divided.

While it can be said that imposing Pigovian tax would lead to a reduction in the level of quantity produced of a commodity by an industry, it can also cause the industries to look upon to new advancements in technologies. This will open doors to research and innovation in the field. For example, the company AkzoNobel Industrial Chemicals is always trying to innovate and make a leap forward in its development to achieve its target to reduce CO2 emissions. Its production facility in Mariager in Denmark uses wood to generate electricity. Wood and other plant-based materials are also used to produce chemical building blocks. Moreover, this shift in technology by commodity producers will cause the externality to be automatically internalised.

Whatever benefits Pigovian taxes might be able to provide, it will usually give diminishing returns past a certain point, where the government might fail to achieve their objectives of meaningfully reducing the excess social costs. Instead, these kinds of taxes would appear to simply become a vehicle by which politicians may raise tax revenue by imposing a discriminatory tax policy aimed at an "undesirable" minority. Therefore, only where institutional and trade solutions are not efficient, the government should consider whether specific interventions, regulation or specific taxes are appropriate to address externalities. These measures are preferable when the net efficiency gains from the intervention are larger than the associated administrative and compliance costs. This suggests that intervention is desirable when externalities are reasonably large.

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WHAT IS PIGOVIAN TAXATION?

Following posts on land value taxation, income taxand the citizen’s income, here’s another recurring idea in new economics – Pigovian taxation. It sounds like something out of Animal Farm. (Its alternative spelling, Pigouvian, might have associations of its own.)Foolishness aside, Pigovian taxation is named for Arthur Pigou, a British economist who explored the role of externalities. Writing in the 1920s, he described how business activity could have unintended and unpriced effects in society. Some of them might be positive, with everybody benefiting at the expense of the business. Others might be harmful, with the business benefitting at society’s expense.

Here’s a trivial example of each from my childhood in Antananarivo. When we used to drive into town, my favourite part of the short journey was when we drove past the coffee roasters on the Route Digue. There was the most wonderful smell that wafted across the highway. We didn’t pay anything for that, it was just a happy effect of the roasting business – a positive ‘uncharged service’ as Pigou called it.

In another part of town there was a community of stone-masons. They broke off chunks of rock from a cliff-face and then chiselled it into blocks by hand. Across that whole district there was the sound of hammering and chipping from dawn to sunset, broken only occasionally by the boom of dynamite blasting instead. It was incessant, noisy, and had a way of burrowing into your brain. Nobody was compensated for the noise and dust from the quarry, that was just an unfortunate effect of the business – an ‘uncharged disservice’, or negative externality.

Pigou was concerned with bigger matters than the smell of coffee roasting, but along the same principles. One of his concerns was alcohol. It’s a legitimate business, but the abuse of alcohol leads to all kinds of social problems, from anti-social behaviour to addiction and liver disease.

Society picks up the tab for those problems through the police and the National Health Service. A tax on alcohol prices in the cost of those externalities so that they’re paid for by retailers and consumers of alcohol rather than society in general. We see a similar approach with cigarettes, gambling, and fossil fuels.

This form of taxation isn’t new, and plenty of countries have had taxes that could be described as Pigovian, even before Pigou described the theory. We’re hearing more about it at the moment because Pigovian taxes have come into their own with climate change. As Lord Stern says, from an economics perspective climate change can be described as a giant market failure – the failure to put a price on carbon. Correcting market failures are exactly what Pigovian taxes are supposed to do.The most obvious form is a carbon tax, like the one Australia has recently brought in. Plenty of other countries have them too. The Scandinavian countries have operated carbon taxes for 20 years. There’s little hope for a carbon tax in the US anytime soon, but local areas and states are free to bring in their own, like Boulder Colorado or the San Francisco Bay area.

There are other routes to the same goal of course. You can legislate strict limits on carbon or create carbon markets under a cap and trade system, but taxes have several benefits – the polluter pays, a revenue stream is generated from something that was formerly a problem, and business incentives are created to reduce carbon, all without heavy handed legislation.

There are problems associated with Pigovian taxes. Externalities are notoriously difficult to price, and some argue that they are mildly regressive. But they’re a tool in the box for creating a fair and sustainable tax system, and one of the most obvious responses to climate change. We should expect to see more of them in future – even China is planning one.