The Pigou tax (also called Pigouvian tax) is a tax that has been proposed to be applied to market participants that generate costs for others (e.g. other market participants) through their activities. Typical examples are a factory polluting a river which is used by a brewery downstream, or a toxin-emitting factory causing health problems in surrounding neighborhoods. In such cases various costs are not covered by the polluter thus undermining the polluter pays principle. Such costs are called negative externalities and result in market failure. The Pigou tax is thus a measure designed to correct this failure. It aims to counter the negative externality and correct the market in order to achieve an efficient level of production. Taxing the external effect, a classical Pigou tax e.g. would be on CO2 emissions not on petrol.
The tax is named after A. C. Pigou, one of the first economists to study the market failure of externalities. In his book The Economics of Welfare, Pigou argues that industrialists seek their own marginal private interest. Quite often the marginal social interest diverges from the marginal private interest, but the industrialist has no incentive to internalize the cost of the marginal social cost. This, of course, also could go the other way round: if an industry produces a marginal social benefit, the individuals receiving the benefit have no incentive to pay for that service.
The difference between the private interest and the societal interest has two major effects. First, as already noted, the market participant creating the social harm does not pay for it. Second, overproduction of the harming product can result where the producer does not consider all of the costs involved.
To tackle over-production, Pigou recommended taxing offending market participants to cover the social cost. The producer would then have to pay for the externality that his production created. This would effectively reduce the quantity of the product produced, moving the economy back to an equilibrium.
Criticisms
Measurement problems
One of the weaknesses of the Pigou tax is the assumption that governments can determine the marginal social cost of a negative externality and convert that amount into a monetary value. In fact such a measurement of social cost is extraordinarily difficult if not impossible, especially because many costs are psychological and individual.
Political problems
Political factors can influence the level of the tax and political processes can complicate its implementation. Lobbying of governments by polluters may tend to reduce the level of tax levied, which will tend to reduce the mitigating effect of the tax. Lobbying of government by special interest groups who calculate the negative utility of the externality as higher than others might conversely increase the level of the tax levied, which would tend to result in a sub-optimal level of production.
Alternatives
Cap and trade Another market based possibility to internalize external costs are tradable permits. Instead of taxing the negative externality producer, governments could regulate the production of that negative externality. They could either establish limits per firm/emitter or place a limit on the total amount of the negative externality and create a market for rights to generate this specific negative externality. However there are many well grounded concerns about market based solutions to pollution control, particularly with regard to carbon trading that should also be considered.
Coasian bargaining Different from market based solutions economist Ronald Coase argued that individuals can agreements with efficient results without the interference of a third party. Such an option, however, would require that the negotiating partners are of similar strength; a situation that rarely exists in cases of environmental externalities.
References
Pigou, A. C. (1920). The Economics of Welfare. London: Macmillan.
This glossary entry is based on a contribution by Sylvia Lorek.
EJOLT glossary editors: Hali Healy, Sylvia Lorek and Beatriz Rodríguez-Labajos.
