Pigouvian tax

A Pigovian tax (also spelled Pigouvian tax) is a tax levied on any market activity that generates negative externalities (costs not internalized in the market price). The tax is intended to correct an inefficient market outcome, and does so by being set equal to the social cost of the negative externalities. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. An often-cited example of such an externality is environmental pollution.

In the presence of positive externalities, i.e., public benefits from a market activity, those who receive the benefit do not pay for it and the market may under-supply the product. Similar logic suggests the creation of a Pigovian subsidy to make the users pay for the extra benefit and spur more production. An example sometimes cited is a subsidy for provision of flu vaccine.

Pigovian taxes are named after English economist Arthur Pigou (1877-1959) who also developed the concept of economic externalities. William Baumol was instrumental in framing Pigou's work in modern economics in 1972.

In 1920, British economist Arthur C. Pigou wrote The Economics of Welfare. In it, Pigou argues that industrialists seek their own marginal private interest. When the marginal social interest diverges from the marginal private interest, the industrialist has no incentive to internalize the cost of the marginal social cost. Conversely, Pigou argues, if an industry produces a marginal social benefit, the individuals receiving the benefit have no incentive to pay for that service. Pigou refers to these situations as incidental uncharged disservices and incidental uncharged services, respectively.

Pigou provides numerous illustrations of incidental uncharged disservices. For example, if a contractor builds a factory in the middle of a crowded neighborhood, the factory causes these incidental uncharged disservices: higher congestion, loss of light, and a loss of health for the neighbors. He also references businesses that sell alcohol. The sale of alcohol necessitates higher costs in policemen and prisons, Pigou argues, because of the crime associated with alcohol. In other words, the net private product of alcohol businesses is peculiarly large relative to the net social product of the same business. He suggests that this is why most countries tax alcohol businesses.

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