Pigovian Tax

A Pigovian [pig-oh-vee-ahn] tax is a levy on a market activity that generates negative externalities (a cost not transmitted through prices that is incurred by a party who did not agree to the action causing it). For example, a tax on cigarettes might be intended to recoup public healthcare costs resulting from smoking. The tax is intended to correct the market outcome, which is not efficient and may lead to overconsumption of the product.

In the presence of positive externalities (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 Pigovian subsidies to make the users pay for the extra benefit and spur more production. Pigovian taxes are named after British economist Arthur Pigou who also developed the concept of economic externalities. William Baumol was instrumental in framing Pigou’s work in modern economics.

In 1920, Pigou wrote ‘The Economics of Welfare,’ where he argued 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. On the flip side, 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 services and incidental uncharged disservices. He 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.

In 1980, a new critique of Pigouvian taxes emerged from economists Dennis Carlton and Glenn Loury. They argued that Pigouvian taxes alone would not create an efficient outcome in the long-run, because the taxes controlled only the scale of the individual firms, not the amount of firms in the particular industry. In the case of pollution, if the firms each produced a fraction of what they produced before, but the number of firms increased exponentially, the amount of pollution would still increase. To prevent this, Carlton and Loury recommend a policy with the potential to regulate the number of firms in an industry: lump-sum taxes or lump-sum subsidies. Carlton and Loury present four basic arguments in their article. First, Pigouvian taxes work in the short-term, because the number of firms cannot vary. Second, Pigouvian taxes do not work in the long-term because the number of firms can vary. Third, an industry with a specific number of firms and scale can achieve the long-run social optimum (LRSO). The best option is to add an entry tax for potential firms and a subsidy for current firms to restrict a movement in the number of firms. Fourth, it is possible for a tax policy to create a LRSO.

NYU mathematician Robert Kohn responded to this article in ‘The Limitations of Pigouvian Taxes as a Long-Rum Remedy for Externalities: Comment,’ saying that a Pigouvian tax on pollution emissions can, in fact, create the long-run social optimum without a lump-sum tax-subsidy. Carlton and Loury responded the same month, clarifying that they were discussing a Pigouvian tax on output; whereas, Kohn was discussing a Pigouvian tax on emissions. Carlton and Loury provide numerical proofs as to why these are different. Ultimately, they argue that there are some cases in which a single tax on emissions will produce the LRSO and others in which a single tax on output will attain the LRSO. Either case only works with the taxes properly determined.

In 1998, economists Don Fullerton and Gilbert E. Metcalf evaluated the double dividend hypothesis, the theory that environmental taxes can improve the environment and increase economic efficiency simultaneously, in ‘Environmental Taxes and the Double-Dividend Hypothesis: Did You Really Expect Something for Nothing?’ Either motivation can legitimately support a tax reform. The first dividend intuitively makes sense: decreasing pollutant emissions improves the environment. The improvement in economic efficiency results from a shift away from distorting taxes such as the income tax. Fullerton and Metcalf note that for every $1 extracted in taxes, a $1.35 burden falls on the economy. In a sense, the private sector must swallow a 35 cent excess burden for no particular reason. The second dividend aims to eliminate some of this excess burden.

Tempting as it may be to try, Fullerton and Metcalf argue, the validity of the double-dividend theory cannot be established as a whole. An observer must evaluate each circumstance individually. Fullerton and Metcalf do provide guidelines for this analysis. Two questions help shape this analysis: what is the status quo? What are the specifics of the reform? The amount and nature of the current taxes, permits, and regulations greatly influence the results of the additional tax. Also, where the tax revenue goes greatly affects the success of the tax. Secondly, Fullerton and Metcalf say the previous literature on Pigouvian taxes focused too heavily on the revenue dividend and too lightly on the environmental dividend of environmental taxes. Their predecessors naively value revenue too much, Fullerton and Metcalf argue, because they fail to recognize that all taxes impose costs on someone. These taxes could outweigh the environmental benefit. Thus, the government must use the Pigouvian tax revenue to lower another tax if it wants to minimize the economic damage of a tax. Fullerton and Metcalf also mention that the effectiveness of any sort of Pigouvian tax depends on whether it supplements or replaces an existing pollution regulation. If the tax replaces a pollution regulation, it will most likely be environmentally neutral, even if it is revenue-positive. If it supplements the regulation, it may or may not be environmentally and revenue-neutral, depending on the effectiveness of the original regulation. The status quo substantially affects the outcome of a proposed tax.

European economists A. Lans Bovenberg and Ruud A. Mooij argue that there is a first-best case scenario and a second-best case scenario in their article ‘Environmental Levies and Distortionary Taxation.’ In the first-best case, the government does not need to get revenue from distortionary taxes such as the income tax, and the Pigouvian tax can create the long-run social optimum. In the real world, second-best case, the status quo includes an income tax that distorts the labor supply. In this situation, Bovenberg and Mooij write that the best tax comes in below the level of the Pigouvian tax. Bovenberg and Mooij establish that households consume a dirty good (D) and a clean good (C). If the government taxes D, it can use the earned revenue to lower the labor income tax. At the same time, the tax levied on the firm will increase the price of D. The lowered income tax and the higher consumer prices even each other out, stabilizing the real net wage. But because C’s price has not changed and it can substitute for D, consumers will buy C instead of D. Suddenly the government’s environmental tax base has eroded and its revenue with it. The government then cannot afford to keep the labor income tax down. Bovenberg and Mooij posit that the increase in the price of goods will outweigh the slight decrease in the income tax. Labor and leisure become more interchangeable the lower the real net wage (or after-tax wage) falls. With this decrease in the real net wage, more people leave the job market. Ultimately, labor bears the cost of all public goods.

Goulder, Parry, and Burtraw agree that that the net social welfare after the implementation of a tax hinges on the preexisting tax rate. Don Fullerton agreed with this analysis in 1997 in his article ‘Environmental Levies and Distortionary Taxation: Comment.’ He added that lowering the income tax and taxing the dirty good equates with raising the labor tax and subsidizing the clean product. These two polices create the same effects, Fullerton says.

Economist Ronald Coase argued that individuals can come to an agreement with an efficient result without the interference of a third party when transaction costs are low. He says it is less expensive and less difficult for two neighbors to come to an agreement about a fence, the amount of noise, or the amount of smoke than it is for these two neighbors to approach a third party to solve the situation for them. Even when several parties are involved, outside interference could result in an inefficient outcome. Instead of taxing the negative externality producer, the government could simply regulate the production of that negative externality. Fullerton and Metcalf argue that restricting the amount of pollution that all firms in an industry can produce will indirectly reduce the output of all firms. This comprehensive supply reduction will automatically raise the consumption price of the good. These types of command-and-control restrictions simulate a cartel, which businessmen typically see as beneficial to profits. Fullerton remarks that production cost per unit does not change, meaning the company can earn profits over and above what it earned before the regulations even with selling a lower quantity of goods. If the production cost of all firms increased simultaneously due to a regulation, the firms may be able to increase the price uniformly. They do not consider the elasticity of products and that’s effect on the quantity of demand and the industry’s final profits.

Another alternative to applying Pigovian taxation is for government to place a limit on the total amount of the negative externality and create a market for rights to generate this specific negative externality. In the United States since the late 1970s, and in other developed nations since the 1980s, the concept of a market for ‘pollution rights’ has arisen. Giving out the rights for free (or at less than market price) allows polluters to lose less profit or even gain profits (by selling their rights) relative to the unaltered market case. Goulder, Perry, and Burtraw suggest that selling permits to firms is the best option, but recognize that many firms in the status quo are grandfathered in, meaning they are given exemptions. The authors include an example of the U.S. regulations in coal-fired electrical power plants that require the reduction of 10 million tons of sulfur dioxide emissions. They estimate that more than half of the $907 million preexisting taxes could have been eliminated by auctioning off the permits rather than grandfathering them.

Most of the criticism of the Pigovian tax relate to the determination of the tax and the implementation. Pigou and Friedrich Hayek point out that the assumption that the government can determine the marginal social cost of a negative externality and convert that amount into a monetary value is a weakness of the Pigovian tax. William Baumol suggests that the measurement of social cost is almost impossible. Ronald Coase argues that all social costs are reciprocal in nature, so, once the tax is set, it must not be changed. Others assert that political factors can complicate the implementation of a Pigovian tax. Arthur Pigou said ‘It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of [the gaps between private and public costs] could interfere with individual choice.’ In other words, the economist’s blackboard ‘model’ assumes knowledge we don’t possess — it’s a model with assumed ‘givens’ which are in fact not given to anyone. Friedrich Hayek would argue that this is knowledge which could not be provided as a ‘given’ by any ‘method’ yet discovered, due to insuperable cognitive limits.

NYU economist William Baumol argues that it is extraordinary difficult to measure the social costs of any externality, especially because many costs are psychological and individual. Even if a measurement of the psychological effect of some externality did exist, it would be impossible to collect that data for all individuals affected and then find the optimum output level. If experts could find the optimum output level, it would be easier to find the optimum Pigouvian tax level to achieve that optimum. In the end, Baumol argues that the best solution is to set a minimum standard of acceptability for negative externalities, and create tax systems to achieve those minimum standards. Baumol points out that government committees have a tradition of agreeing on minimum standards, so the practicality of this solution is reasonable.

Ronald Coase argues that the tax placed on an industry creating a negative externality should not be changed after it is implemented. The crux of his argument is that all social costs are reciprocal in nature. Coase argues that a factory emitting smoke is not entirely responsible for the social harm of smoky air. If the factory were not there, no one would suffer from smoky air, and if the people were not there, no one would suffer from smoky air. Because of this reciprocity of harm, Coase argues that neither party bears sole responsibility for the social harm, so neither party should pay the full cost. The social harm gets worse, Coase argues, if only one offender pays for the social harm. If the smoke-emitting factory must pay dearly for all its smoke, it will reduce its quantity of production or buy the necessary technology to reduce its smoke rate. With the advent of clean air, neighbors may move into the area. This immediately increases the marginal social cost of smoke, which would require a tax increase on the factory. Essentially, each time the tax increases, the population increases and the marginal cost of the status quo increases again, so the factory is punished for making conditions good enough that people want to move there.

One complexity of this situation is the multiple local maxima, or the interchangeable best-case scenarios. It all hinges on the numbers. If the cost of abating all smoke is more than the cost to move the neighbors out, the neighbors should move out and let the factory continue emitting smoke. On the other hand, if it costs less to abate the smoke than to move the neighbors, then the factory ought to pay the tax or buy the clean technology to provide clean air for the surrounding residents. Once the optimum solution is implemented, Coase argues that the tax should not change, regardless of changing circumstances. In this case, if a tax is imposed on the factory and some more neighbors move in, the factory tax should not increase.

Political factors such as lobbying of government by polluters may also tend to reduce the level of the tax levied, which will tend to reduce the mitigating effect of the tax; lobbying of government by special interests who calculate the negative utility of the externality higher than others may also tend to increase the level of the tax levied, which will tend to result in a sub-optimal level of production. In their article ‘On Taxation and the Control of Externalities: Comment,’ Earl A. Thompson and Ronald Batchelder noted one political problem with Pigouvian taxes. If a firm can influence the tax rate or regulations put on it, the results will not be as certain as Pigou and Baumol suggested. Baumol responded to this, saying that almost all discussions on Pigouvian taxes include the assumption of pure competition. This certainly does alter the scenario, but the literature had not ignored it; it had merely used a different set of assumptions.

Thomas A. Barthold argues in 1994 that actual policy decisions often come from budget requirements, not concern for the environment. The taxes do not always parallel raw economic theory because social benefits and costs are hard to measure. He uses the 1989 Montreal Protocol as an example. President George H. W. Bush signed this protocol that allowed either a permit auction or a tax on ozone-depleting chemicals. Barthold attributes the decision to implement the tax to the pressure on the Ways and Means committee to come up with more consistent revenue. The tax policy also did not accord with basic common sense economic principles. For one, it makes sense to impose a tax on the industry that creates the pollution problem and on the activity that emits the harmful chemicals. This particular activity happened to be the use of automobiles with leaky compressor systems, but because of the high administration cost of taxing that many people, the government decided to tax the producers of those chemicals, though they contributed nothing to the actual problems of chlorofluorocarbons in the atmosphere.

Another evidence of the alternative motivations for this policy is the fact that the base tax increases annually. Does the harm from chlorofluorocarbons increase every year and in the same increment? Who is to say that $1.37 per pound of chlorofluorocarbons is an accurate description of the marginal social cost of pollution? The conspicuous hike in the tax in 1992 that equalized the Energy Policy Act’s budget ignited Barthold’s suspicions. Additionally, exporting firms should not receive exemptions from environmental taxes simply because they are exporting goods. If the motivation for this tax was simply the first dividend, environmental improvement, then all firms, whether or not they export, would be taxed. Aside from this frustration, Barthold noted that politicians often prefer regulations with obvious benefits and hidden costs to regulations with hidden benefits and obvious costs. This is one reason why politicians often prefer to hand out permits to firms rather than impose a tax on them, even though the tax is more economically efficient. Free permits create winners of grandfathered firms and losers of the consumer who has to pay more for the same product. According to Barthold, taxation makes losers of the factory producers and indirect winners of the consumers.

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