Neo-classicals uphold perfect competition as the ideal state of the market. But in truth, the economy is fraught with market failures. Therefore, we need government interference to correct many of these market failures. Pigovian Tax imposed by the government is one such course of intervention. It helps to curb negative externalities (e.g. pollution) and reduce the burden on the society caused by the externalities (social costs of production and consumption). Moreover, it attacks over-consumption, bringing it closer to the socially optimal level of production and/or consumption. The paper examines the effects of Pigovian tax and analyses its degree of effectiveness on an economy.

What is Pigovian Tax?

Pigovian tax is a kind of tax, which is levied to correct a negative cost that is created by the actions of any business firm, but that is not considered in a firm’s private costs or profits. Also known as ‘sin tax’, it is a tax placed on an action with a negative externality, to correct market failure (Mankiw, 2010). In the presence of negative externalities, the social cost  of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient  and may lead to over-consumption of the product. A Pigovian tax equal to the negative externality is thought to correct the market outcome back to the level of efficiency.

For example, a factory does not financially take into consideration the damages caused to the environment by their emissions. By imposing Pigovian Tax, the government can artificially make the firms bear the cost of the damages, which will ideally be equal to what the price would have been if a market for such an activity existed. In a country like Canada with a publicly funded health care system, that is, where the medical service of every patient is funded from government revenues, the cigarette tax acts as a Pigovian tax – it raises the revenue necessary to offset the expenses towards the health care system, as a consequence of smoking.

Pigovian Tax in Implementation

This idea was first put forward by Arthur Cecil Pigou in the year 1912. In his book, The Economics of Welfare, he argued that industrialists seek their own marginal private interest, while not taking into account the social costs of their activities.