What is a Pigovian tax?

A Pigovian tax is a corrective tax imposed on businesses or individuals for the exercise of certain activities. The purpose of the Pigou tax is to discourage specific activities that impose a net production cover on third parties. These costs are known as negative externalities in economics and are named after the English economist Arthur C. Pigou who made important contributions to the theory of externality. The Pigovian tax is used to minimize the negative consequences of externalities, such as highly polluting industries.

Negative externalities

Normally, negative externalities are not necessarily “bad”. However, when the manufacturer fails to internalize the cost of their business, third parties must subsidize the extra production cost reluctantly. Environmental pollution is the best negative externality. Factory pollution becomes a negative externality because the expense of such pollution is explained by neighboring third parties. These costs can come as health risks or property damage. The polluter only bears the marginal private costs while the community pays marginal external costs. As such, the economy of that neighborhood can suffer a sharp loss if pollution exceeds optimal social levels.

Mitigation of negative externalities

A British economist Arthur Pigou introduced the concept of a Pigovian tax while developing the economic theory of externalities. In his influential book “Economic Welfare ” Pigou argues that industrialists are always looking for their private marginal interests. It states that state intervention is the best way to correct negative externalities. Pigou argues that scientifically measured and selective taxation can compensate for such a phenomenon. The government must estimate private marginal cost and marginal social costs to obtain the Pigovian tax.

Criticism of the theory: the problem of social costs

Pigou’s theory has been a mainstream theory for almost forty years, until Ronald Coase published the Nobel book “The Problem of Social Costs” in 1960. In his book, Coase’s analytical framework showed that ideas and Pigou’s solutions were in most cases wrong. Coase provided three reasons why Pigou’s ideas proved ineffective. First of all, negative externalities do not necessarily determine an inefficient market result. Secondly, even with the occurrence of an inefficient result, the Pigovian taxes do not lead to an efficient result. Finally, Coase stated that the critical element was not a theory of externalization, but a theory of transaction costs. Another negative aspect of the Pigovian tax is the calculation and knowledge problems. For a government to issue the exact Pigovian social tax, it should estimate the most efficient result.

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