Pigouvian tax

A Pigouvian tax (also spelled Pigovian tax) is a tax on a market activity that generates negative externalities, that is, costs incurred by third parties. It imposes costs corresponding with the externalities, internalizing those costs to improve Pareto efficiency. Ideally, the tax is set equal to the external marginal cost of the negative externalities, in order to correct an undesirable or inefficient market outcome (a market failure).

In the presence of negative externalities, parties who did not consent to the transaction or activity, and did not receive payment, nevertheless incur some of the costs, so the total cost is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to a harmful excess of the activity. Examples of negative externalities are environmental pollution and increased public healthcare costs associated with tobacco and sugary drink consumption.

Conversely, in the presence of positive externalities, those who did not directly participate in the market activity, or contribute to the production, receive some benefit, and the market may under-produce. This suggests a Pigouvian subsidy to help consumers pay for socially beneficial products and encourage increased production to generate more positive societal benefits.

Examples are a subsidy for flu vaccines, for research and development, and for public goods such as education and national defense.

Pigouvian taxes are named after the English economist Arthur Cecil Pigou (1877–1959), who developed the concept of economic externalities. William Baumol was instrumental in framing Pigou's work in modern economics in 1972.