Pigouvian Tax: Definition, Overview & Examples

KEY TAKEAWAYS

• A Pigouvian tax is made with the intention of taxing the producer of goods or services that create adverse side effects for the general public.
• Some economists say that the costs of these adverse side effects such as environmental pollution are borne by society. Absolving the blame for the producer.
• The main purpose of the Pigouvian tax is to redistribute the cost of these negative effects back to the producer or the user of the negative product.
• Examples of a Pigouvian tax are the carbon taxes, sugar taxes, or the tax on plastic carrier bags.
• Pigouvian taxes are supposed to be equal to the cost of the negative externality. However, it can be difficult to determine as the external social costs may vary by location and can harm society if they are overestimated.

What Is a Pigouvian Tax?

A Pigouvian tax is a tax that is assessed against private businesses or individuals. Specifically, it applies to entities that engage in activities that create adverse side effects for society. Adverse side effects are costs that aren’t included as a part of the product’s market price. These include things such as strains on public healthcare from the sale of harmful materials such as tobacco products, as well as any environmental pollution. It also includes any other side effects that have a negative external impact. 

Pigouvian taxes were named after English economist Arthur Pigou. Pigou was a significant contributor to the early externality theory.

Advantages of Pigouvian Tax

There are a number of advantages that economists have outlined for the Pigouvian tax. One is that Pigouvian taxes tend to correct for negative externalities that are a burden on the public. For example, the pollution that comes from a factory can manifest itself in health issues among the population such as lung cancer. This can then result in further costs and strain on the health care system. 

If the polluter was forced to pay a tax, it would help to offset the economic costs associated with resulting health problems. It would also discourage the factory from generating as much pollution in the first place.

Disadvantages of Pigouvian Tax

The Pigouvian theory was dominant in mainstream economics for 40 years. However, they lost favor after Nobel Prize-winner Ronald Coase presented his ideas. Coase demonstrated that Pigou’s examination and solutions were commonly incorrect for three separate reasons:

1. Negative externalities didn’t always lead to an inefficient result.
2. Even if the results were inefficient, Pigouvian taxes didn’t always lead to an efficient result. 
3. The critical element is transaction cost theory, no eternality theory. Some of the common transaction costs include labor, transportation, commissions, or bank charges.

How to Calculate Pigouvian Tax

Accurately calculating a Pigouvian tax is an incredibly complicated process. This is because, in theory, the Pigouvian tax’s amount should be equivalent to the expense of the negative externality. 

It goes without saying that figuring out the externality’s cost might be challenging, and different circumstances will require different calculations. This makes it a complicated process as it will change depending on the circumstances.

Examples of Pigouvian Tax

A good example of a Pigouvian tax is the carbon emissions tax. Governments impose a carbon emissions tax on any company that burns any form of fossil fuels. This is because fossil fuels emit greenhouse gasses which directly affect global warming. 

Other examples include:

• Tobacco taxes
• Sugar taxes
• Gasoline taxes
• Noise taxes

Difference Between a Pigouvian Tax and a Sin Tax

These two taxes are relatively similar. The main difference is that a Pigouvian tax aims to minimize negative externalities, while sin taxes focus on reducing negative internalities. 

For example, a tax on alcohol deters people from developing a habit that could lead to internal problems like alcoholism or liver damage. Tax revenue may be used to support public awareness initiatives about the risks associated with drinking. The levied tax would have to  equal costs associated with treating liver problems in order to be considered Pigouvian. So in this case, the liquor tax would be both a Pigouvian tax and a sin tax.

Summary

The idea of externalities was created by a British economist Arthur Pigou. He claimed that in order to fix them, the government should impose taxes on activities that hurt the economy as a whole and provide subsidies for those that benefit society as a whole.

Pigouvian taxes are a somewhat effective way to place the burden of negative externalities back onto the producer. While their effectiveness has been debated by various economists, they serve as a good deterrent.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.