Pigouvian Tax
A tax on economic activities that generate negative externalities
What is Pigouvian Tax?
Pigouvian Tax is a tax on economic activities that generate negative externalities, which create costs that are borne by unrelated third parties. The costs arising from negative externalities are not reflected in the final cost of a product or service. Therefore, the market becomes inefficient.
The main purpose of Pigouvian taxes is to oppose market inefficiencies by increasing the marginal private cost by the amount generated by the negative externality. In such a case, the final cost (original cost plus tax) will reflect the full social cost of the economic activity. Subsequently, the negative externality will be internalized.
Pigouvian taxes can be imposed to challenge the following activities:
- Environmental pollution
- Harmful substances (tobacco and alcohol)
- Congestion
The Pigouvian Tax is named after British economist Arthur C. Pigou, who was one of the most prominent contributors to the externality theory in the early 1900s.
Learn how to construct the three financial statements with our Free Accounting Fundamentals Course.
How Does a Pigouvian Tax Work?
Under free market conditions, a negative externality establishes a market equilibrium when the social marginal benefit (SMB) is equal to the personal marginal cost (PMC₁), which is lower than the social marginal cost (SMC) due to the additional costs created by the economic activity. Such a market equilibrium is not efficient.
In the ideal world, the Pigouvian tax will be imposed at an amount equal to the costs associated with the negative externality. When Pigouvian taxes are imposed, the supply of the economic activity producing the negative externality will decrease.
Therefore, the quantity demanded will decrease, while the price will increase. Therefore, the market equilibrium will become socially efficient because the social marginal cost will become equal to the private marginal cost.
Advantages of Pigouvian Tax
In some cases, Pigouvian taxes can effectively deal with the problem of negative externalities. Some of the advantages include:
1. Fosters market efficiency
Pigouvian taxes promote market efficiency by incorporating the additional costs imposed by negative externalities.
2. Discourages harmful activities
In certain cases, Pigouvian taxes may effectively discourage the activities that lead to negative externalities. For example, the introduction of a carbon tax may place a significant burden on a company that produces substantial emission gases. Therefore, a company may decide to transfer to operations that produce fewer emission gases.
3. Generates additional government revenue
Pigouvian taxes generate additional revenues for the government. The additional funds may be used to subsidize initiatives and programs that will further challenge negative externalities.
Disadvantages
Despite their benefits, Pigouvian taxes are frequently criticized because of the following reasons:
1. Hard to measure
In theory, Pigouvian taxes must be equal to the costs generated by the negative externality. However, in the real world, the precise measurement of such costs is not always possible. Thus, in practice, the taxes are less effective than in theory.
2. Political issues
The imposition of Pigouvian taxes is frequently associated with political problems. Government attempts to introduce such taxes generally face resistance from lobbyists who support parties that can be affected by the taxes (e.g., tobacco producers). Therefore, such taxes are not always an optimal solution from a political perspective.
Additional Resources
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep learning and advancing your career, the additional CFI resources below will be useful:
Financial Analyst Certification
Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!
