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What is A Pigouvian Tax?

A Pigouvian tax, also spelled as Pigovian tax, is a tax which is implied on any market activity which generates negative externalities and it is intended to correct an inefficient market outcome, which is done by being set equal to the social cost of the negative externalities. Negative externalities are not necessarily bad in the normative sense, but they rather occur when whenever an economic actor does not fully internalize the costs of their activity, which also means that the third party has to unwillingly subsidize the extra production. This however, does not affects the small industries as much.

The origin of Pigouvian tax goes back to 1920 when the British economist Arthur C.Pigou wrote The Economics of Welfare, in which he mentions and argues that the industrialists seek their own marginal private interest rather than social interest. According to his theory, the divergence between the marginal private interest and the marginal social interest generates two primary results, such as: the party who is receiving the social benefit has not paid for the same whereas the party who is creating the social harm has not the paid for it either, and secondly, when the marginal social cost exceeds the private marginal benefit, the cost-creator tend to over produce the product. So, in order to deal with the over production, he recommended a tax placed on the offending producer, with the aim of reducing the quantity of the product produced and thus moving the economy back to a healthy equilibrium. In his theory, he has provided numerous examples of incidental uncharged services, for example, if a contractor builds a factory in the middle of a crowded neighborhood, the factory will cause the incidental uncharged disservices, higher congestion, loss of light, and a loss of health for the neighbours.

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The Pigouvian tax is a method which is most commonly used by the UK government because of its low transaction costs involved in the transactions. There are other methods as well, such as command and control regulations or subsidies, but since their implementation demand complete and thorough knowledge of the market, which is never the case, and can lead to inefficiencies and market failure.

A popular example of a Pigouvian tax is a tax on the pollution. Pollution from a factory creates a negative externality because part of the cost of the pollution is paid by the third party neighbors and this cost might manifest either through dirtied property or through risk in their health. Whereas the person who has installed the factory has only considered or internalized the marginal private costs and not these marginal external costs. So, according to the theory of Pigou, once these external costs are added, he has argues that the economy suffered deadweight loss from excess pollution beyond healthy or social optimal level.

Although Pigouvian tax works good with the government, but if external costs are overestimated by the lawmakers, Pigovian taxes could cause more harm than good. So, once Pigouvian tax was scrutinized, both on theoretical and practical front, economists have found holes in the theory. One major objection which was raised was its incompleteness because Pigouvian theory holds everything else in the economy fixed, which is not true and thus the effectiveness of a Pigouvian tax will depend on the level of competition in the market it is affecting.

What is A Pigouvian Subsidy?

Pigouvian Subsidy

A Pigouvian subsidy, also spelled as Pigovian subsidy, is a subsidy provided to an activity on the grounds that the activity generates external benefits i.e. positive externalities. It is closely related to Pigouvian taxes and is normally provided by the government or the regulatory bodies. However, unlike the Pigouvian taxes, Pigouvian subsidies could in principle be provided through private philanthropy.

Pigouvian subsidy focus on positive externalities, which is basically something which helps to progress the society as a whole and it results from an economic transaction which has positive external effects on the third parties. One such example of positive externality is the market for education. The more education a person receives, the greater the social benefit. Another common example of positive externality is behavior or steps to reduce the pollution by cutting down on the dependency on fossil fuels. To do so, the government might give a subsidy to howeowners who are interested in buying solar panels for their house. For example, if the government offers a 20% subsidy on residential solar systems and the cost of installing such system is approx £20,000, then the total cost to the homeowner will be £16,000. In other words, a consumer subsidy increases demand and decreases price for the consumer.

While positive externalities are enjoyed by the third party as a result of an economic transaction, they do not pay for the same and hence are considered to the free-riders, which in fact is in favour of the society to encourage free-riders to consume goods which generate substantial external benefits.

How to Encourage Positive Externalities?

Positive externalities can be encouraged through various ways and government should implement economic policies to promote the same. However, there are two general approaches to promote positive externalities, such as:

1. Increase the supply: One way to promote and encourage positive externalities is to reduce the cost of production and thus increase the supply of such goods and services. This approach is implemented to increase the supply of merit goods such as health care, education and social housing. Public goods like roads, bridges and airports, also generate positive externalities and thus can be funded out of central and local government taxation to encourage the supply of the same.

2. Increase the demand: Another way to promote and encourage positive externalities is by increase in demand of such goods and services, which is done by reducing the cost of those goods and services. For example, if the tuition fee of the university students is reduced, it will encourage more and more student to opt for the education and thus will have a positive effect on the society as a whole. Another way of doing the same is by compelling the individuals to consume the goods or services which generate the external benefits. For example, in case of a suspected contagious disease, individuals may be forced to receive the treatment even if it is against their will.

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