Pigouvian Taxes, Their Pros and Cons, and Whether They Work

Why Is Gasoline Taxed?

woman pumping gas
••• A gasoline tax is a Pigouvian tax.  Photo by Dream Pictures/Getty Images

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.

For example, pollution is an externality. The driver of a non-compliant vehicle doesn't really suffer from the exhaust as he drives down the road. But everyone behind him does. His exhaust also increases pollution on everyone in the community. The government impose a Pigouvian tax on non-compliant vehicles to make the driver suffer more of the cost. It often directs the revenue from the tax to ameliorate the external costs.

Ideally, a Pigouvian tax will cost the producer the amount equivalent to the harm it causes others. For example, a manufacturer poisoned the groundwater in its first five years of operations. It costs the nearby town $1 million to clean it up. The manufacturer emitted 100,000 gallons of waste during that period. 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.

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

An example of both a sin tax and Pigouvian tax is a cigarette tax. It discourages smokers from engaging in a habit that will create a harmful internality, 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.

Examples

The gasoline tax is Pigouvian. It seeks raise the driver's cost to cover the negative externalities created by the automobile. In the United States, the federal gas tax is $0.184 per gallon. The average of all state taxes is $0.2785 per gallon. The revenue go into the federal Highway Trust Fund to pay for roadway maintenance. But Congress hasn't increased the tax since 1993. As a result, the revenue isn't enough to keep the Highway Trust Fund solvent.

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 are Pigouvian. They increase the costs to carbon emitters who don't pay for the environmental damage. Higher carbon levels cause climate change. It destroys creates greater natural disasters, raises sea levels, and increases droughts. The tax corrects this externality by raising the price to reflect this social cost.

Pigouvian Taxes Work

In 2002, Ireland taxed plastic bags. Retailers charge 0.15 euros for each bag at the register. Within a few weeks, plastic bag usage fell 94 percent. One year later, everyone had bought reusable cloth bags. It cut their use by over 90 percent. The revenue goes to the environment ministry for enforcement and clean up. In 2007, the tax rose to 0.22 euros. 

In 2003, the city of London launched a Congestion Charge for driving in central London during work days. It was between 9-12 pounds depending on time of day and how far into the city the driver went. 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.

In 2008, British Columbia introduced a carbon tax. It covers 70 percent of the province's greenhouse gas emissions. The first year, it charged C$10 per ton of carbon dioxide equivalent emission. That tax rose $5 a ton each year until reaching C$30 per ton in 2012. The rate translates to C$0.0667 a litre of gasoline, and C$0.0767 per litre in diesel. The revenue goes toward tax reductions and increased benefits.

Between 2007 and 2014, emissions fell 5.5 percent despite a 8.1 percent increase in population. Real gross domestic product rose 12.4 percent during that period. Canada adopted a similar carbon tax in 2018. it starts at C$10 per ton and will rise to C$50 per ton in 2022. 

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 create more efficiency in an economy. The tax equals 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

Pigouvian taxes are regressive when they impose a harsher burden on the poor than the rich. Because it's a flat tax, Pigouvian taxes take a greater percentage of a poor person's income. A $10 tax takes more out of $100 than it does out of $1,000. It becomes more regressive if it is imposed on goods and services the poor are more likely to use. 

For example, cigarette taxes are a regressive Pigouvian tax. A 2015 Gallup Poll found that the lowest-earning fifth allocated 1.3 percent of their spending on cigarettes, compared to 0.3 percent for the highest-earning fifth. On the positive side, low income people are more responsive to higher Pigouvian taxes. The poorest half of smokers reduced their cigarette consumption four times more than the richest half did. As a result, the poor paid 11.9 percent of the tax increase, but received 46.3 percent of the benefit as measured by fewer deaths.

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

History

British economist Arthur Pigou developed the concept of externalities. He argued that the government should intervene to correct them. It should tax activities that harm the economy as a whole. It should subsidize activities that help society as a whole. For example, many gifted students may not be able to afford advanced education. But they would benefit the economy if their gifts were developed through education. Pigou argued that the government must subsidize activities that create these positive externalities.

Pigou lectured at Cambridge University until World War II.