Plain Sense Economics

A Pigovian tax (named after economist Arthur Pigou) aims to correct negative externalities. In plain-sense English this means that when a private market has a negative effect on others, a tax can sometimes offset that negative effect. The additional feature of a Pigovian tax is that it lets the private parties work out the best solution, and is often more flexible and efficient that direct regulation. Read Greg Mankiw’s Manifesto on Pigovian Taxes here.

Here’s a recent example. From the Chicago Tribune on November 14, 2008:

Want to stop people from drinking too much? Forget earnest public service announcements. Just make alcohol more expensive.

A study released Thursday by the American Journal of Public Health found that when the tax rate on alcohol went up, deaths caused by drinking went down.

So, in this case the purchase and consumption of alcohol has a negative externality – a larger number of deaths in society. A higher death rate imposes a social cost – to innocent victims of drunk drivers, to lost productivity, and to related damage. A tax on alcohol is a Pigovian tax. It does not ban the purchase of alcohol, but the higher resulting price provides an incentive to change purchase and consumption behavior. The study mentioned in the article provides a link between the tax and reduced alcohol-related deaths.

The principal challenge in creating a Pigovian tax is estimating what the social costs are, and setting a tax that recovers those costs. And, we know that imposing a tax, particularly an excise tax on something like alcohol, results in deadweight loss – a net loss in combined consumer and producer surplus.