# Pigovian Tax Explained: Definition, Purpose, and Real-World Examples

![Pigovian Tax: A tax assessed against businesses and private individuals who engage in activities that adversely effect society.](https://www.investopedia.com/thmb/MAgbOe6NaNr4TVFRu_6Jv-b0Yog=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/pigoviantax.asp-final-a78bc547584a49188d20d174ae660e67.png)

*— Investopedia / Tara Anand*

## What Is a Pigovian Tax?

A Pigovian (also spelled Pigouvian) tax is a tax on market transactions that create negative externalities, or adverse side effects, for those that are not directly involved in the transaction.

Common examples of a Pigovian tax include carbon taxes to offset the environmental pollution from using gasoline, or tobacco taxes to address the strain on public healthcare systems caused by consuming tobacco products. These taxes help to shift the burden of these externalities back to the producers and consumers who cause them. However, it can be difficult to get a reliable estimate of the economic harms caused by these activities.

Pigovian taxes were named after English economist Arthur Pigou, a significant contributor to early [externality](https://www.investopedia.com/terms/e/externality.asp) theory. Pigou also promoted the link between the balance of consumption, employment, and price, known as the [Pigou effect](https://www.investopedia.com/terms/p/pigou-effect.asp).

### Key Takeaways

*   Pigovian taxes are designed to mitigate negative externalities by taxing activities that harm society or the environment.  
    
*   These taxes aim to align private costs with social costs, encouraging producers to reduce negative impacts.  
    
*   Examples of Pigovian taxes include carbon emissions taxes and taxes on tobacco and alcohol.  
    
*   Calculating the right Pigovian tax can be challenging, leading to potential inefficiencies if miscalculated.  
    
*   Critics argue that Pigovian taxes may disproportionately impact lower-income groups.

## How Pigovian Taxes Work

A Pigovian tax is a way of discouraging [negative externalities](https://www.investopedia.com/terms/e/externality-of-production.asp), or activities that impose a cost on third parties and society. According to Pigou, negative externalities prevent a market economy from reaching equilibrium when producers do not take on all costs of production. He suggested that this might be corrected by levying taxes that were equal to the externalized costs. Ideally, the tax would also give the producer an incentive to reduce the negative externalities they are responsible for.

Negative externalities are not necessarily "bad." Instead, a negative externality occurs whenever an economic entity does not fully internalize the costs of its activity. In these situations, society and the environment can end up bearing those additional costs.

A common example of a Pigovian-style tax is a tax on pollution. Pollution from a factory creates a negative externality because third parties bear part of the cost of production. This cost might manifest itself through contaminated property, [destroyed wetlands and streams](https://www.investopedia.com/articles/dictionary/031615/understanding-basics-mitigation-banking.asp), or health risks. The polluter only takes into consideration the private costs, not the external costs.

Once Pigou factored in external costs to society, the economy suffered [deadweight loss](https://www.investopedia.com/terms/d/deadweightloss.asp) from excess pollution beyond the "socially optimal" level. Pigou believed that state intervention should correct negative externalities, which he considered a [market failure](https://www.investopedia.com/terms/m/marketfailure.asp). He suggested that this be accomplished through taxation.

## Pros and Cons of Pigovian Taxes

### Advantages

Some economists support Pigovian taxes because they help fix [negative externalities](https://www.investopedia.com/terms/t/truecosteconomics.asp), reducing public burdens. For example, air pollution from a factory may result in health issues like lung cancer among the population.

The theory suggests that taxing polluters can offset economic costs and discourage excessive pollution. This means that Pigovian taxes benefit society and tend to improve social welfare, so long as they are properly applied.

### Disadvantages

Pigou's externality theories were dominant in mainstream economics for 40 years, but lost favor after Nobel Prize-winner [Ronald Coase](https://www.investopedia.com/terms/r/ronald-h-coase.asp) demonstrated that Pigou's examination and solution were often wrong, for at least three separate reasons:

1.  Negative externalities did not necessarily lead to an inefficient result.
2.  Even if they were inefficient, Pigovian taxes did not tend to lead to an efficient result.
3.  The critical element is transaction cost theory, not externality theory.

Pigovian taxes also face "calculation and knowledge problems," as noted by economist [Ludwig von Mises](https://www.investopedia.com/terms/l/ludwig-von-mises.asp). A government cannot impose the correct Pigovian tax without knowing in advance what the most efficient outcome is. This would require knowing the precise amount of the externality cost imposed by the producer, as well as the correct price and output for the specific market.

 If lawmakers overestimate external costs, critics argue Pigovian taxes might harm more than help, especially affecting lower-income groups.

Pros

*   Reduce negative externalities
    
*   Promote social welfare
    
*   Can generate tax revenue
    

Cons

*   Pigovian taxes are difficult to calculate properly
    
*   Imposing the wrong tax would be inefficient and costly
    
*   Taxes like gas taxes can hit low-income consumers hardest
    

## Real-World Examples of Pigovian Taxes

Although some disagree with Pigou's theories, Pigovian taxes are common today, like the [carbon emissions tax](https://www.investopedia.com/terms/c/carbon-dioxide-tax.asp). Some governments impose these taxes on any company that burns fossil fuels. When burned, fossil fuels emit greenhouse gases, which cause global warming, damaging the planet in a multitude of ways.

The carbon tax aims to include the true cost of burning fossil fuels, paid by society. The end goal of the carbon tax is to ensure that the producers of the emissions are the ones incurring this external cost.

Europe and Canada often use Pigovian taxes on plastic, and sometimes paper, bags. This encourages consumers to bring their own reusable bags from home instead of consuming more plastic and paper. Plastic is a byproduct of burning fossil fuels and results in damage to marine life, while paper bags can exacerbate deforestation. By charging even a small amount, such as a few cents per bag, the tax discourages their production and consumption.

[Taxes on "sin" items](https://www.investopedia.com/terms/s/sin_tax.asp) like alcohol and cigarettes can also be construed as Pigovian taxes. This is because they discourage behavior that can not only harm the individual user, but also have damaging effects on others. Second-hand smoke is an obvious example, but so is the financial burden on the healthcare system from smokers who become ill with cancer or emphysema. Alcohol is responsible for drunk driving accidents, including injuries and deaths among innocent others.

These examples show negative externalities where product prices ignore societal costs. The respective taxes are meant to redistribute those costs back to the producer (or product user) that caused the negative externality.

> **Fast Fact**
>
> Gasoline taxes can be considered Pigovian taxes since they aim to discourage unnecessary driving, and proceeds are used to build, repair, and upgrade transportation infrastructure that benefits society. Each state has its own gas tax in the U.S., and as of January 1, 2024, the federal government imposes an additional gas tax of 18.4 cents per gallon for unleaded gasoline (24.4 cents for diesel).

## What Is a Negative Externality?

In economics, a negative externality is a negative byproduct of an individual, business, or industry that the creator of the byproduct does not pay for. Instead, society pays the price. Examples include air and noise pollution, toxic runoff, and the inadvertent killing of pollinators through pesticides, among others.

## What Is the Difference Between a Pigovian Tax and a Sin Tax?

Pigovian taxes and sin taxes are quite similar, and a specific levy may satisfy both definitions. The key difference is that a Pigovian tax seeks to minimize negative externalities (i.e., harms to others or society as a whole), while sin taxes typically seek to reduce negative internalities (i.e., harms to oneself). In the case of cigarettes and alcohol, for example, there are both potential negative internalities and externalities.

## How Do You Calculate a Pigovian Tax?

Calculating a Pigovian tax is notoriously difficult to get right. In theory, the amount of the tax should be exactly equal to the net cost of the externality it seeks to remedy. Thus, the tax represents the difference between the social cost and the marginal private cost at a given level of production.

## The Bottom Line

While few people (aside from professional economists) may recognize the name, Pigovian taxes are widely used today for common goods like gasoline, tobacco, and sugar. These taxes seek to compensate for the social harms caused by using these products.

There are, however, some doubts about the effectiveness of Pigovian taxes, with critics citing the disproportionate impacts on populations with lower incomes.

Pigovian taxes can be contrasted with Pigovian subsidies, which are government benefits that aim to encourage transactions that have positive benefits to society. An example of a Pigovian subsidy is public education funding.

> **Article Sources**
>
> 1.  The History of Economic Thought. "[Arthur Cecil Pigou, 1877-1959](https://www.hetwebsite.net/het/profiles/pigou.htm)."
>     
> 2.  U.S. Energy Information Administration. "[How Much Tax Do We Pay on a Gallon of Gasoline and on a Gallon of Diesel Fuel?](https://www.eia.gov/tools/faqs/faq.php?id=10&t=5)"
>     
> 3.  Core-Econ.org. "[Leibniz 12.3.1: Pigouvian Taxes](https://www.core-econ.org/the-economy/book/text/leibniz-12-03-01.html#:~:text=The%20tax%20is%20equal%20to,cost%20is%20equal%20to%20%24300.)."
>     
> 4.  The Tax Foundation. "[Piguovian Tax Definition](https://taxfoundation.org/taxedu/glossary/pigouvian-tax)."