Pigovian taxes are named after economist Arthur Pigou (1877-1959), who also developed the concept of economic externalities. William Baumol was instrumental in framing Pigou's work in modern economics.
The diagram to the right illustrates the working of a Pigovian tax. (For an explanation of this type of diagram, see social cost.) A tax shifts the marginal private cost curve (MPC) up by the amount of the tax (to MPC + T). Faced with this cost increase, the producers have an incentive to reduce output to the socially optimum level (Qs) by reducing the marginal externality to the marginal tax. The total tax revenue (which could be used to mitigate the effect of the negative externality) is equal to the area 0EAB.
A key problem with Pigovian tax is that of calculating what level of tax will counterbalance the negative externality. Political factors such as lobbying of government by polluters may also tend to reduce the level of the tax levied, which will tend to reduce the mitigating effect of the tax; while lobbying of government by special interests who calculate the negative utility of the externality higher than others may also tend to increase the level of the tax levied, which will tend to result in a sub-optimal level of production.
A Pigovian tax is considered one of the "traditional" means of bringing a modicum of market forces, and thus better market efficiency, to economic situations where externality problems exist. More recently, particularly in the United States since the late 1970s, and in other developed nations since the 1980s, an alternative to Pigovian taxation has arisen: the creation of a market for "pollution rights." Pollution rights markets are not generally more efficient than Pigovian taxes but are often more appealing to policy makers because giving out the rights for free (or at less than market price) allows polluters to lose less profits or even gain profits (by selling their rights) relative to the unaltered market case. Markets for emissions trading have been set up to bring better allocative efficiency and improved information sharing to the pollution externality problem. Pollution rights markets are a part of the field of Environmental Economics generally, and Free-market environmentalism specifically.
Perhaps the biggest problem with the Pigovian tax is the "knowledge problem" suggested on page 6 of Pigou's essay "Some Aspects of the Welfare State" (1954) where he writes, "It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of [the gaps between private and public costs] could interfere with individual choice." In other words, the economist's blackboard "model" assumes knowledge we don't possess — it's a model with assumed "givens" which are in fact not given to anyone. Indeed, this is knowledge which could not be provided as a "given" by any "method" yet discovered, due to insuperable cognitive limits theorized by economists like Friedrich Hayek and researchers in the various fields of nonlinear dynamics.
Economic theory predicts that in an economy where the cost of reaching mutual agreement between parties is high, and where pollution is diffuse, Pigovian taxes will be an efficient way to promote the public interest, and will lead to an improvement of the quality of life measured by the Genuine Progress Indicator and other human economic indicators, as well as higher Gross domestic product (GDP) growth.
Economic theory predicts that, under certain conditions, a double dividend could appear. The first is the reduction of pollution. The second consists in the recycling of the government revenue from the green tax. If the government keeps its revenue constant, some other taxes have to be cut (see Green tax shift). If the government chooses to cut the most distortional taxes, the costs of the swap to green taxes could be negative.
Research on green taxation suggest that during the 1990s there was significant correlation between a country's UN Human Development Index (HDI) rank per fixed amount of GDP, and its level of green tax as a percentage of total tax revenues. Furthermore, over periods longer than 5 years, data suggest that countries having higher green tax rates such as Norway, Sweden and Netherlands experience higher GDP growth and higher HDI growth rate. . However, it cannot be confirmed that an increase in green tax rates causes higher GDP growth and higher HDI growth rates. It may be a correlative effect as opposed to a causal effect.
The motivation for such a subsidy is trying to reach economic efficiency. When a positive externality is present, a firm's solution of its utility maximization problem does not account for the additional utility (to another agent) produced as a by-product (the externality), thus causing the firm to produce less than the pareto-efficient level . The Pigouvian subsidy thus internalizes the externality into the agent's utility function, by giving the firm incentive to produce more than it otherwise would.
An example would be a central government transfer that accounts for interjurisdictional spillover (usually in the form of matching grants).
Mentioned in Oates, Essay in Fiscal Federalism
If lower income individuals tend to spend a greater portion of their income on the product with external social costs, such as cigarettes or electricity, then the corresponding Pigovian tax is regressive.