What is a Pigovian Tax?

Jessica Ellis

A Pigovian tax, also known as a “sin tax,” is a tax levied to correct a negative cost that is directly created by the actions of business, but that is not considered in business costs or profits. This type of tax is a way for government to maintain stability and equity in the market by looking at a broader picture than the simple buying and selling of goods and services allows. Pigovian taxes are somewhat controversial in politics, with detractors claiming they are a means of punishing companies for high profit levels. Proponents argue that measures such as a Pigovian tax help protect the rights of all citizens instead of placing a premium on the rights of corporations.

Man climbing a rope
Man climbing a rope

There are two desired outcomes of a Pigovian tax: to correct the external negative costs through revenue, and to give businesses an incentive to behave in ways that do not trigger the tax. If a mining operation does substantial damage to nearby rivers by disposing byproducts unsafely, the government may step in to repair damage done to the rivers. In order to pay for these repair efforts, a Pigovian tax might be enacted to generate the revenue necessary. In addition, the tax might be high enough to make it more economically feasible for the mining operation to engage in environmentally safe procedures rather than pay the tax.

While simple enough in concept, a Pigovian tax becomes highly difficult to enact through tax policy. To begin with, government officials with voting power may be motivated to reduce or reject the tax based on lobbying by business interests, personal politics, or concerns for the impact on re-election caused by voting for the tax. Through amendments, exemptions, and other additions to the original proposal, the tax may be reduced to the point when it is no longer efficient at accomplishing either of its goals. If it is then passed, the tax can create a dual problem: the business might lose profits enough to trigger layoffs or hurt production, but not enough to change its ways, and the government might not collect enough revenue to correct the original problem. Thus, a tax meant to be a win-win situation can quite quickly transform into a losing venture for everyone.

Another key problem in enacting a Pigovian tax is determining the right levels for taxation to create both incentive and sufficient revenue. While negative externalities, such as damage to rivers, can be estimated, they are difficult to pin down into exact figures. Additionally, determining the amount of tax to charge businesses to incentivize change but not unduly damage production is based on a wide variety of market and economic variables that make an exact tax rate nearly impossible to determine. Though excellent in theory, Pigovian-style taxes tend to be far more to manage efficiently in reality.

In some cases, a Pigovian tax can be enacted on individual consumers rather than businesses. This type of tax is usually levied on consumer products that are seen as creating an overall social negative effect, such as tobacco. In this case, the tax is meant to create incentive for consumers to stop buying the product due to higher costs, while also providing revenue for programs such as lung cancer research, government health care, and costs that can be traced back to the product.

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