Pigouvian Tax

A Pigouvian tax (also spelled Pigovian) is a tax on an activity that imposes costs on people who are not part of the transaction, set so that whoever causes the harm pays for it. Pollution, traffic congestion, smoking and heavy drinking are standard examples. Unlike most taxes, its main purpose is to change behaviour, not to raise money, although it does raise revenue as a by-product.

The idea is named after the Cambridge economist Arthur Cecil Pigou (1877–1959), who set it out in The Economics of Welfare, published in 1920. It is the classic policy answer to a negative externality, one of the main types of market failure. A carbon tax is the most prominent modern example. The opposite tool, a Pigouvian subsidy, rewards activities with benefits to others, such as vaccination or research.

Suppose a factory upstream dumps waste into a river, and the fishermen downstream lose their catch. The factory's own costs do not include the fishermen's losses, so it makes more waste than it would if it had to pay for the harm. A Pigouvian tax puts a price tag on that harm, so the factory weighs it the same way it weighs electricity or wages.

The government does not have to tell the factory exactly what to do. Once the damage has a price, the factory decides for itself whether to cut output, clean up its process or pay the charge, and it will usually choose whichever is cheapest.

When an activity harms others, its full cost to society is the private cost plus the external cost:

• $\text{MSC}$ is the marginal social cost, the full cost to society of one more unit.
• $\text{MPC}$ is the marginal private cost borne by the producer, a version of marginal cost.
• $\text{MEC}$ is the marginal external cost, the damage to third parties from one more unit.

The textbook rule is to set the tax per unit equal to the marginal external cost at the socially efficient level of output:

Here $Q^{*}$ is the output at which the benefit of the last unit equals its full social cost. For example, if each tonne of a pollutant causes $40 of damage to nearby residents at the efficient level of output, the tax should be $40 a tonne. The producer then treats the pollution as a $40 cost, cuts emissions wherever cleaning up costs less than $40 a tonne, and pays the tax on the rest. This moves the market toward a Pareto efficient outcome in standard supply and demand analysis.

• Carbon and fuel. Carbon taxes and fuel duties price greenhouse gases and local air pollution.
• Congestion charges. Singapore introduced an area licensing scheme for central roads in 1975, and London has charged drivers to enter its centre since 2003. Both are designed to price the delay each vehicle imposes on others.
• Tobacco, alcohol and sugar. Excise duties, a form of indirect tax, on cigarettes and drinks are partly justified by health costs that fall on public health systems. Mexico introduced a tax of one peso per litre on sugar-sweetened drinks in 2014, and the UK's Soft Drinks Industry Levy took effect in April 2018, prompting many makers to cut sugar content.
• Plastic bags and waste. Charges on single-use carrier bags and landfill taxes price litter and pollution, a local version of the tragedy of the commons.

Some of these levies are hypothecated, with revenue earmarked for related spending such as public transport or health, which can make them easier to accept politically.

The strongest theoretical challenge came from Ronald Coase in his 1960 article "The Problem of Social Cost". He argued that harm is reciprocal and that, if property rights are clear and bargaining is cheap, the parties can negotiate an efficient outcome without a tax. This insight, known as the Coase theorem, shifted attention to transaction costs and legal rights. In practice, when many people are affected, as with climate change, bargaining is rarely feasible, which is why Pigouvian taxes remain popular among economists.

Other criticisms include:

• Measurement. Governments rarely know the true marginal damage, so rates are often set by guesswork or politics, or by cost-benefit analysis built on contested assumptions.
• Political capture. Public choice economists warn that governments may set rates to maximize revenue rather than correct harm, or exempt powerful industries.
• Fairness. Taxes on fuel, tobacco and sugar take a larger share of poorer households' budgets, making them a regressive tax in their direct effect.
• Weak response. Where demand is fairly inelastic, as with cigarettes, a tax may raise money without changing behaviour much; the price elasticity of the taxed good matters.

Supporters reply that pricing harm is still cheaper than detailed rules, and that revenue can offset other taxes, a claim sometimes called the "double dividend". The economist Greg Mankiw coined the name "Pigou Club" for economists who favour higher fuel and carbon taxes in exchange for lower taxes on income.

• IMF Finance & Development: Externalities: Prices Do Not Capture All Costs