Pigovian Tax

Pigouvian Tax

Pigouvian taxes are corrective taxes/strategic fee levied against private individuals or businesses for engaging in a specific activity that causes certain negative externalities as a consequence of it.  It is named after economist Arthur C. Pigou, who developed the idea in his book “The Economics of Welfare”, 1920.

To put in simple terms Pigouvian tax is the one used/imposed in order to diminish the negative fallouts of externalities. For example it is generally imposed on high polluting industries which not only causes harm to environment but poses health risks to the people living nearby.

Pigou said that negative externalities prevent a market economy from reaching equilibrium. Pigou believed that the onus lies on state and it is the States responsibility to intervene and correct negative externalities. Thus we can say that Pigouvian theory is based on the method of modern economics especially based on welfare economics.

This somehow lost ground after Ronald Coase published “The Problem of Social Cost” (1960). Coase demonstrated that Pigou’s examination and solution were often wrong, and for at least three separate reasons. Here we take one example where Coase say that so called negative externalities are a complex business and must be avoided. He says, it is not as simple as “one side damages the other side“.

For example, in the case of chemical factory vs. residents, it is unfair to tax the factory without discussing whether the factory has the right to emission or not. Because, it may be the case that the factory is established years before any resident areas was setup, and in this case, the factory may have the emission rights(The example of factory vs resident is from Ronald Coase”The problem of Social Cost”, Journal of Law and Economics Vol 3:1(1960)).

Other issues with the Pigouvian Tax are:

First, the use of Pigovian solution is based on the premise that the government knows the cause of externalities and can calculate all marginal costs or benefits, however it is impossible for any government to obtain all information to make a Pareto optimal allocation of resources. Second, the government intervention also makes costs. If the cost of Government intervention is more than the losses caused by externalities, then there is no reason for use to use government intervention .Third, the Pigovian solution may cause the rent-seeking activities, which will lead to waste of resources and distortions of resource allocation.

Term is important for Preliminary Examination.