Pigouvian Taxes, Their Pros and Cons, and Examples

A Pigouvian tax is a government cost on any activity that creates socially harmful externalities. An externality is an activity that creates a negative effect on others in a society but not necessarily the person who does that activity.

Pollution is an externality, for example. Drivers of non-compliant vehicles don't suffer immediately from their exhaust, but everyone behind them does. Their exhaust also increases pollution for everyone in the community.

The government imposes Pigouvian taxes on non-compliant vehicles to impose a higher cost on the drivers to compensate for the suffering they cause. The revenue from the tax is often used to ameliorate the external cost.

British economist Arthur Pigou developed the concept of externalities. He argued that the government should intervene to correct them by taxing activities that harm the economy as a whole and subsidizing activities that help society as a whole.

Examples of Pigouvian Tax

Let's imagine a manufacturer poisoned the groundwater in its first five years of operations. The manufacturer emitted 100,000 gallons of waste during that period, and it cost the nearby town $1 million to clean it up. The town would impose a $1 million fine for past behavior.

The town would also impose a Pigouvian tax of $10 a gallon going forward. That would cover the cost of future pollution. If it was worth it to the firm to continue making its toxin-producing product, then it would pay the fine. If not, then it would go out of business. Either way, the town will have clean water.

Gas Taxes

A gasoline tax is an example of a Pigouvian tax. It raises the driver's cost to cover the negative externalities created by driving automobiles. In the United States, the federal gas tax was $0.183 per gallon in 2019. The average state gas tax was $0.2868 per gallon. The revenue goes into the federal Highway Trust Fund to pay for roadway maintenance.

Noise Taxes

France levies a Pigouvian noise tax on airplanes at its nine busiest airports. It ranges from 2 euros to 35 euros depending on the airport and the weight of the aircraft. The government uses the revenue to soundproof houses that are exposed to noise levels beyond 70 decibels.

Carbon Taxes

About 40 countries impose carbon taxes on companies that burn coal, oil, or gas, which produce greenhouse gas emissions. These emissions cause climate change, which can bring about more natural disasters, raise sea levels, and increase droughts.

Although Pigouvian taxes may work in one sense, they can have some unanticipated or unintentional negative effects.

Pros 

Pigouvian taxes discourage behaviors that create negative externalities. In situations where it doesn't, it raises revenues to help those affected by the externality. For example, the gasoline tax reduces driving while funding highway maintenance.

Pigouvian taxes can also create more efficiency in an economy, especially when the tax covers the cost of the external damage. It creates the true cost of producing the good or service. The business then decides whether it is worth the extra cost. 

Cons

Ideally, Pigouvian taxes equal the costs generated by the negative externality. These costs can be difficult to measure in the real world.

Pigouvian taxes are regressive when they impose a harsher burden on the populations with lower incomes compared to those with higher incomes.

Like any other kind of government intervention, Pigouvian taxes can have unanticipated negative effects. In 1995, the Netherlands imposed a groundwater tax. It imposed the tax on drinking water companies in order to preserve clean drinking water for future generations. The government allowed too many exemptions, and as a result, 10 companies paid 90% of the tax. These same companies lobbied to end the tax. In 2011, the Dutch government revoked the tax for being fiscally inefficient.

Sin Tax Versus Pigouvian Tax

A Pigouvian tax is similar to a sin tax, which also imposes costs on socially harmful goods or services, but sin taxes are designed to discourage internalities or negative effects that occur for the user. Lung cancer is an example of an internality borne by cigarette smokers.

A cigarette tax discourages smokers from engaging in a habit that will create a harmful internality, such as lung cancer. It also uses tax dollars to fund campaigns that educate people about the dangers of lung cancer. To be truly Pigouvian, the tax would be equivalent to society's cost of treating lung cancer.

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