Pigouvian Tax
A Pigouvian tax is a tax levied on an activity that generates a negative externality, set equal to the marginal external cost at the efficient level of output. Named after the economist Arthur Pigou, such a tax aligns the private cost of the activity with its social cost, so that producers and consumers take account of the harm they impose on others. The tax reduces the quantity of the activity to the socially optimal level, and it raises revenue that can be used to reduce other taxes or to compensate those affected.
The externality problem
An externality arises when an activity affects others without those effects being reflected in market prices. Pollution from production, congestion from driving, and noise from airports are examples of negative externalities, in which the social cost exceeds the private cost, so that too much of the activity occurs. Because the market price does not include the external cost, producers and consumers have no incentive to take it into account, and the outcome is inefficient.
The efficient level of the activity is where the marginal social benefit equals the marginal social cost, which is lower than the market level when there is a negative externality. A Pigouvian tax equal to the marginal external cost at that level raises the private cost to the social cost and induces the efficient quantity. The tax thus corrects the market failure by changing the prices faced by the parties.
Design and implementation
The design of a Pigouvian tax requires an estimate of the marginal external cost, which is often uncertain and varies with the level and location of the activity. For pollution, the appropriate tax may vary by source and by location, because the harm depends on where and when the emissions occur. A uniform tax may be administratively simpler but less accurate, and the choice involves a trade-off between precision and practicality.
Implementation requires a basis for taxation, such as the quantity of emissions, the content of a product, or the use of a resource. Taxes on carbon content, on fuel, and on waste are examples. Monitoring and enforcement are needed to ensure compliance, and the revenue must be collected and used. The tax rate must be set and updated, and its credibility and predictability affect the investment decisions of firms and households.
Advantages
Pigouvian taxes have several advantages. They achieve the efficient level of the activity at the lowest cost, because they allow each polluter to decide whether to reduce emissions or to pay the tax, so that reductions occur where they are cheapest. This cost-effectiveness is a major advantage over command-and-control regulation, which prescribes specific technologies or limits and may achieve the same reduction at higher cost.
The taxes also raise revenue, which can be used to reduce distortionary taxes on labour or capital, generating a double dividend, or to fund compensation for those affected or investment in alternatives. The revenue makes the policy more attractive and can offset the regressive effects of higher prices, and it provides resources for measures that support the transition to cleaner technologies.
Limitations and concerns
Pigouvian taxes face limitations and concerns. The measurement of external costs is difficult, and errors in the estimate lead to taxes that are too high or too low, reducing the efficiency gain. The taxes may be regressive, because they raise the prices of goods that form a larger share of the budgets of lower-income households, such as fuel and energy, and they require accompanying measures to offset the distributional effects.
The taxes may also be ineffective if the demand for the taxed activity is inelastic, so that the reduction in quantity is small, or if substitutes are unavailable. They may be evaded or avoided, particularly where the activity can be shifted to other jurisdictions. And they may face political opposition, because the costs are visible and concentrated while the benefits are diffuse, which is why the design of accompanying measures and of communication is important for their adoption.
Comparison with other instruments
Pigouvian taxes are one of several instruments for addressing externalities. Command-and-control regulation sets standards or requires particular technologies, and it can be effective where the externality is severe or where monitoring is difficult, but it may be less cost-effective because it does not allow firms to choose the cheapest abatement. Tradable permit systems cap the total quantity and allow trading, and they achieve the cap at the lowest cost, but they leave the price of emissions uncertain.
The choice among the instruments depends on the circumstances. Taxes provide price certainty but quantity uncertainty, while permits provide quantity certainty but price uncertainty. Where the marginal cost of abatement is steep relative to the marginal damage, permits may be preferable, and where the reverse, taxes may be. Hybrid instruments combine features of both, and the choice also depends on the administrative capacity and on the political economy of the policy.
Revenue use and the double dividend
The revenue from a Pigouvian tax can be used in several ways, each with different implications. Using the revenue to reduce distortionary taxes on labour or capital can generate a double dividend, improving both environmental quality and economic efficiency. Using it to compensate affected households can address distributional concerns. Using it to fund investment in clean technology can accelerate the transition.
The existence and size of the double dividend are debated. The revenue recycling can improve efficiency, but it may also reinforce the effects of the tax on the taxed activity, and the net effect depends on the structure of the tax system and on the responses of households and firms. The empirical evidence suggests that the efficiency gains from recycling can be substantial, and that the design of the recycling is as important as the tax itself.
Political economy
The adoption of Pigouvian taxes faces political obstacles. The costs of the tax are visible and concentrated, falling on particular industries and households, while the benefits are diffuse and accrue over time. This asymmetry makes it difficult to build coalitions in support of the tax, and it can lead to resistance from affected groups. The use of the revenue to compensate those affected, or to fund visible benefits, can improve the political feasibility.
The credibility and predictability of the tax also matter for its effectiveness. Firms and households need to know the future path of the tax to make investment decisions, and uncertainty about future rates can delay the adoption of cleaner technologies. Announcement of a long-term path, with gradual increases, can provide the needed predictability and can allow adjustment, and the experience of several countries with carbon pricing illustrates the importance of the design of the transition.