# Pigouvian Tax

When was the first time that you heard about Pigouvian taxes and subsidies? It's when you learn about externalities. At that time, you might have thought that Pigouvian taxes and subsidies are an elegant solution to the problems of negative and positive externalities. But are there situations where a Pigouvian tax is not the best idea? What if there are uncertainties involved? Read our article to learn about Pigouvian taxes and their advantages and disadvantages. We have also ensured that there are enough examples and graphs of the Pigouvian taxes to help you understand the concept thoroughly!

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## Pigouvian Tax Definition

Pigouvian taxes are taxes that are designed to correct negative externalities. Therefore, they are also known as corrective taxes.

Pigouvian taxes are often used in the context of pollution. They are designed to make the polluters take into account the external costs of pollution in their production decisions.

Pigouvian taxes are named after the British economist Arthur Cecil Pigou, who developed the concept of externalities.

Need a refresher? Check out our explanation: Negative Externalities.

## Pigouvian Tax Graph

The pigouvian tax graph helps us understand how this tax can solve the problem caused by negative externalities.

Fig. 1 - An industry will over-produce in the presence of a negative externality.

The graph above (Fig. 1) shows a situation facing an industry with a negative externality. Without any regulations in place, the firms will produce a quantity of Q1, the point where their supply curve intersects with the demand curve. The marginal social cost (MSC) curve is higher than the supply (MC) curve, and the difference between them is given by the marginal external cost (MEC) curve. The MEC curve is upward-sloping because the harmful effects of pollution become substantially larger as the quantity increases.

Figure 1 shows an entire industry's situation as the demand curve is downward-sloping. A single firm in a perfectly competitive market will face a flat marginal benefit curve.

We know that imposing a tax on pollution can help solve the negative externality problem, but how high should we set the Pigouvian tax?

Figure 2 shows a firm's perspective. Assume that the profit-maximizing level of production will produce E1 level of emissions. Without any regulations, the firm will emit this amount of pollution. When a Pigouvian tax is implemented, the firm has the option to take certain actions and purchase some equipment to reduce emissions.

Fig. 2 - The efficient level of emissions.

The firm faces a downward-sloping marginal cost of abatement (MCA) curve, but it's helpful to read it from right to left. As the firm chooses to abate a larger amount of emissions, the marginal cost of doing so is higher because it has to take more costly actions to change its production procedures or buy more sophisticated emissions-control equipment.

The efficient level of emissions is E* because that's where the MCA and the MEC curves intersect. The government should set the Pigouvian tax at the amount of P* which targets the level of emissions at point E*.

## Pigouvian Tax Examples

The most common examples of Pigouvian tax are carbon emissions, sugary drinks, or plastic bag taxes. Let's take a closer look at some real-world examples of the Pigouvian taxes together:

#### A Pigouvian tax provides an incentive for further reduction.

Compared to a traditional emission standard, a Pigouvian tax also provides an incentive for firms to reduce their emissions further. Looking at Figure 5 again, if Firm 2 acquires some new equipment that shifts its MCA curve to MCA1, it will reduce its emissions to level 9. In the case of an emission standard, it will still have the incentive to acquire the equipment to lower its abatement cost, but it will only reduce its emissions to level 10 and has no incentive to reduce them further.

### Pigouvian Tax: Cons

In the real world, we don't always know what the marginal external cost (MEC) curve or the marginal cost of abatement (MCA) curve looks like. Sometimes, this information is not available to the government because the MCA for a firm is a business secret. In other cases, there is actual scientific uncertainty regarding what the MEC of emissions is. In these scenarios, it is tricky to say which kind of regulation is better. It depends on the shapes of the two curves.

Fig. 6 - The MEC curve is steep, and the MCA curve is relatively flat.

Figure 6 shows that when the MEC curve is steep and the MCA curve is relatively flat, a traditional emission standard is better. If the government makes a small error in setting the emission standard (at the level of ES), this will lead to a net increase in social costs the size of the yellow area. On the other hand, if the government makes an error of the same proportion in setting the Pigouvian tax (at PT), this will lead to a net increase in social costs the size of the red and yellow area combined, which is a lot larger.

In the opposite situation, when the MCA curve is steep and the MEC curve is relatively flat, then a Pigouvian tax is preferable to a traditional emission standard given the uncertainty and potential error.

There is a market-based intervention that targets the quantity of pollution like traditional regulations. To find out more, go check out our explanation: Tradeable Pollution Permits.

In the case of setting a price for carbon, the uncertainty in the marginal damage of each additional ton of carbon emissions can explain in part the significant variation in the prices of carbon emissions under different settings. Figure 7 below shows the implied carbon prices under different carbon taxes and emissions trading systems (ETS) in different places.

Fig. 7 - The significant variation in carbon prices under different carbon taxes and emissions trading systems. Source: World Bank.

### Pigouvian Tax - Key takeaways

• Negative externalities lead to over-production, and positive externalities lead to under-consumption.
• Pigouvian taxes are taxes that are designed to correct negative externalities. They are also known as corrective taxes.
• Pigouvian subsidies are subsidies that are designed to correct positive externalities.
• A Pigouvian tax is usually more efficient than the traditional command-and-control type of regulations.
• When there are uncertainties regarding the MEC or MCA curves, it is tricky to say which kind of regulation is better. It depends on the shapes of the two curves.

## References

1. Figure 3: World Bank. 2021. State and Trends of Carbon Pricing 2021. Figure 2. Washington, DC: World Bank. © World Bank. https://openknowledge.worldbank.org/handle/10986/35620 License: CC BY 3.0 IGO.
2. Figure 7: World Bank. 2021. State and Trends of Carbon Pricing 2021. Figure 2.4. Washington, DC: World Bank. © World Bank. https://openknowledge.worldbank.org/handle/10986/35620 License: CC BY 3.0 IGO.
3. British Columbia Government, British Columbia's Carbon Tax, https://www2.gov.bc.ca/gov/content/environment/climate-change/clean-economy/carbon-tax
4. Transport for London, Congestion Charge, https://tfl.gov.uk/modes/driving/congestion-charge
5. WHO, Taxes on sugary drinks. Why do it?, https://apps.who.int/iris/bitstream/handle/10665/260253/WHO-NMH-PND-16.5Rev.1-eng.pdf
6. South Dublin City Council, Plastic Bag Levy, https://www.sdcc.ie/en/services/environment/recycling-and-waste/waste-regulations/plastic-bag-levy/#:~:text=The%20Plastic%20Bag%20Levy%20was,meats%20and%20certain%20other%20products.

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What are Pigouvian tax and subsidies?

Pigouvian taxes are taxes that are designed to correct negative externalities. Pigouvian subsidies are subsidies that are designed to correct positive externalities.

What is the purpose of a Pigouvian tax?

To make the economic actor take into account the marginal external cost of their actions.

Are pigouvian taxes efficient?

Pigouvian taxes are usually more efficient than the traditional command-and-control type of regulations. An exception is when the MEC curve is steep and the MCA curve is relatively flat, then a traditional emission standard (or a quantity target) is better.

What are the advantages of the Pigouvian tax?

1. Lower cost in achieving the same amount of emission reduction.

2. A Pigouvian tax provides an incentive for further reduction of social costs.

What happens when a Pigouvian tax is imposed?

In the case of a firm, it shifts up the supply curve, and the output will decrease accordingly.

## Test your knowledge with multiple choice flashcards

What problems do Pigouvian taxes and subsidies address?

What kind of externalities do Pigouvian taxes correct?

Pigouvian subsidies address which kind of externalities?

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