Pigouvian tax
A Pigouvian tax (also spelled Pigovian tax) is a tax on any market activity that generates negative externalities (i.e., external costs incurred by third parties that are not included in the market price). A Pigouvian tax is a method that tries to internalize negative externalities to achieve the Nash equilibrium and optimal Pareto efficiency.[1] The tax is normally set by the government to correct an undesirable or inefficient market outcome (a market failure) and does so by being set equal to the external marginal cost of the negative externalities. In the presence of negative externalities, social cost includes private cost and external cost caused by negative externalities. This means the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product.[2] Often-cited examples of negative externalities are environmental pollution and increased public healthcare costs associated with tobacco and sugary drink consumption.[3]
In the presence of positive externalities (i.e., external public benefits gained by society that are not included in the market price), those who did not consent to be part of the market activity receive the benefit, and the market may under-produce. Similar logic suggests the creation of a Pigouvian subsidy to help consumers pay for socially beneficial products and encourage increased production to generate more positive societal benefits.[4][5]
An example sometimes cited is a subsidy for the provision of flu vaccines and the public goods (such as education and national defense), research & development, etc.[6][7]
Pigouvian taxes are named after English economist Arthur Cecil Pigou (1877–1959), who also developed the concept of economic externalities. William Baumol was instrumental in framing Pigou's work in modern economics in 1972.[3]
Pigou's original argument[edit]
In 1920, British economist Arthur Cecil Pigou published The Economics of Welfare.[8] In it, he argues 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 marginal social cost. Conversely, 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 disservices and incidental uncharged services, respectively.
Pigou 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.
The divergence between the marginal private interest and the marginal social interest produces two primary results. First, as already noted, the party receiving the social benefit does not pay for it, and the one creating the social harm does not pay for it. Second, when the marginal social cost exceeds the marginal private benefit, the cost-creator over-produces the product. Ultimately, because non-pecuniary externalities overestimate the social value, they are over-produced.
To deal with over-production, Pigou recommends a tax placed on the offending producer. If the government can accurately gauge the social cost, the tax could equalize the marginal private cost and the marginal social cost. In more specific terms, the producer would have to pay for the non-pecuniary externality that it created. This would effectively reduce the quantity of the product produced, moving the economy back to a healthy equilibrium.
Lump-sum tax[edit]
In 1980, a new critique of Pigouvian taxes emerged from Dennis Carlton and Glenn Loury.[9] 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 number 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.
Robert Kohn responded to this article in "The Limitations of Pigouvian Taxes as a Long-Run 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.[10] 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.[11] 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.
Double-dividend hypothesis[edit]
The double-dividend hypothesis proposes that a revenue-neutral substitution of environmental taxes for revenue-raising taxes might offer two benefits. The idea was first advanced by Tullock (1967) in a paper titled 'Excess Benefit'.[12] The first benefit (or dividend) is the benefit or welfare gain resulting from a better environment and less pollution (caused by a Pigouvian tax imposed on the producer), and the second dividend or benefit is a more efficient tax system due to a reduction in the distortions of the revenue-raising tax system, which also produces an improvement in welfare. This idea received scant attention until the early 1990s when the economics of climate change attracted attention to the topic of environmental taxes. The term 'double dividend' became widely used following its introduction by David Pearce in 1991. Pearce noted that estimates of the marginal excess burden (marginal distortionary cost) of existing levels of taxation in the US economy are between 20 and 50 cents per dollar of revenue collected. Because the revenue from the carbon tax would be recycled (used to lower preexisting and distorting taxes), the policy would be revenue-neutral, and the secondary benefit from revenue recycling would justify an even higher carbon tax. It is generally accepted now that the magnitude of the "revenue-recycling" benefit is lower than the 20–50 cents per dollar of revenue, but there are differing views on whether the second effect is positive or negative. The line of argument suggesting that the second "benefit" is negative proposes a previously unrecognized "tax interaction effect" (Bovenberg and de Mooij 1994).[13]
In a 1997 paper, Don Fullerton and Gilbert E. Metcalf evaluated the double dividend hypothesis.[14] They define the double-dividend hypothesis as the theory that environmental taxes can improve the environment and increase economic efficiency simultaneously. 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. This does not imply that the double dividend hypothesis is untenable but there is just more complication to that. 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.
Distortionary taxation[edit]
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."[15] 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 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".[16] 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 policies create the same effects, Fullerton says.
In 1998, Fullerton and Gilbert E. Metcalf explain this theory more thoroughly. They begin by defining terms. The gross wage reflects the pre-tax wage a laborer receives.[14] The simplest form of the net wage is the pre-tax wage minus the income tax. In reality, however, the net wage is the gross wage times one minus the tax rate, all divided by the price of consumption goods. With the status quo income tax, deadweight loss exists. Any addition to the price of consumption goods or an increase in the income tax extends the deadweight loss further. Either of these scenarios lowers the net wage, reducing the supply of labor offered. The supply of labor decreases because of the labor/leisure interchange. If someone gets paid very little, he or she may decide it is no longer worth his or her time to continue in that job. Thus, employment decreases. If the Pigouvian tax, which increases the price of consumption goods, replaces the income tax, Fullerton argues that the net wage is not affected.
This rejection of the double dividend hypothesis found in the "tax interaction" literature was met with surprise and skepticism among economists for a variety of reasons. There are multiple sources of ambiguity, differing definitions of what constitutes a 'double dividend', and confusion caused when comparing models with direct versus indirect tax programs, reliance on comparisons with an unreliable benchmark, and misinterpretation of notation in the literature.
Although the central question for the double dividend hypothesis and the tax interaction literature has been whether the welfare gains from environmental taxation in a second-best world are larger or smaller than in a first-best setting, the Tax Interaction literature takes this central question and frames it indirectly, by asking whether the second-best optimal environmental tax is higher or lower than the first-best Pigouvian rate. This question, too, is not answered directly, because the first-best Pigouvian rate is replaced by a definition of marginal social damages, the value of which changes with the tax level and tax program normalization. This becomes an unreliable and shifting benchmark (Jaeger 2011).[17]
In retrospect, three factors contributed to misleading interpretations in the TI literature: an algebraic error, the use of an unreliable benchmark, and unrecognized compounding or double taxation. As a result, the conclusion that a large, previously unnoticed distortionary tax interaction effect existed can be seen as partly due to misinterpretations (Jaeger 2013).[18]
Despite these sources of confusion, it remains the case that a) the possibility of a double dividend depends on specifics specific to the demands and the economy in which an environmental tax is being considered, and b) that the efficiency gains with revenue recycling will be greater, potentially significantly greater, than when revenues are not collected and used to reduce pre-existing revenue-raising taxes. Various research studies using numerical models find evidence in support of the double dividend hypothesis (Jorgensen et al., 2013).[19]
Despite the recent controversy on this topic, the conclusions that can be drawn are in keeping with economic intuition. Environmental and revenue-raising taxes are complementary tools for achieving two different kinds of government goals: the provision of public goods with revenue-motivated taxes and the protection of environmental quality with corrective taxes. Indeed, the joint pursuit of these two goals through taxation can enable the government to justify doing more of each by making the optimal environmental tax higher than it would be otherwise, and by lowering the distortionary cost of financing the provision of public goods.