Pigouvian Taxes, Their Pros and Cons, and Examples

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Pigouvian tax is a government cost on activities that create 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. The driver of a non-compliant vehicle doesn't necessarily suffer immediately from the exhaust it releases as they drive down the road, but everyone behind them may suffer. Their exhaust may also increase pollution for everyone in the community.

The government imposes a Pigouvian tax on non-compliant vehicles to make the driver take on more of the cost of the suffering they may cause. The revenue from the tax is often used to help ameliorate the external cost.

Ideally, a Pigouvian tax will cost the producer the amount equivalent to the harm it causes others.

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. But it 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 another example of a Pigouvian tax. It seeks to raise 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, and the average state tax for gasoline 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, raises sea levels, and increase droughts.

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

Pros

  • Discourages undesirable behaviors

  • Encourages economic efficiency

  • May generate additional government revenue

Cons

  • May further disadvantage people with lower income

  • Can backfire and create the opposite of the desired effect

  • Difficult to measure

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. However, these costs can be difficult to measure in the real world.

Pigouvian taxes can also be considered regressive when they impose a harsher burden on the populations with lower incomes compared to those with higher incomes. Some Pigouvian taxes, such as the gas tax or cigarette tax, are considered regressive because they're flat, or the same for everyone. That means they end up taking take a greater percentage of income from people who make less money.

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

Effective Pigouvian Taxes

Some governments have seen success with their Pigouvian tax initiatives:

Ireland: Plastic Bag Tax

In 2002, Ireland began taxing the use of plastic bags. Within a few weeks, plastic bag usage fell 94 percent. One year later, everyone had bought reusable cloth bags. The revenue goes to the environment ministry for enforcement and clean-up.

London: Congestion Charge

In 2003, the city of London launched a Congestion Charge for driving in central London during work days. Three years later, congestion inside the zone had fallen by a quarter. After 10 years, congestion was still down by 10.2 percent. As a result, journey times did not increase. The city uses the funds for its transport system.

British Columbia: Carbon Tax

In 2008, British Columbia introduced a carbon tax that now covers about 70 percent of the province's greenhouse gas emissions. Between 2007 and 2014, emissions fell 5.5 percent despite an 8.1-percent increase in population, and real gross domestic product rose 12.4 percent during that period.

Sin Tax vs. Pigouvian Tax

A Pigouvian tax is similar to a sin tax, which also imposes costs on socially harmful goods. 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 can be considered both a sin tax and Pigouvian tax. It 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. But to be truly Pigouvian, the tax would be equivalent to society's cost of treating lung cancer.