A Pigouvian Tax Issues - Report Example

The objective of this essay is to elaborate upon Pigouvian taxes. The focal point is to be the advantages this type of tax has compared to the alternative of regulation. The disadvantages of Pigouvian taxes shall also be discussed. However, since to understand the notion of a Pigouvian tax it is imperative to perceive the notion of economic externalities, the essay shall start off by introducing the concept of an economic externality and what problems it leads to. It shall thereon move on to discuss what exactly is meant by a Pigouvian tax and how that can solve the problems associated with the presence of externalities. Following this lead, the advantages of such a tax over the alternative mechanism of regulation shall be analysed and finally, the problems of a Pigouvian tax scheme will be discussed. An externality in essence refers to the phenomenon of one individual or firms production or consumption decision affecting the production or consumption of another individual without the latter. being directly involved. Pollution is a negative externality implying that the polluters production activities cause disutility or increase in costs of others. Consider for instance the situation of two producers A and B with A producing something that includes using water from the river (for instance, for disposal of waste) and this usage reduces the fish productivity of the river and B being a fisherman. The more A increases his production, the greater will be the cost of production for B since he will be able to catch lesser fish per unit of time, labor or capital. The idea of the Pigouvian tax is to make the polluters production costs become inclusive of the damage that he does. Since the changes in the fish productivity of the river does not affect producer A, he has no incentive on his own to produce below his private optimum. However, if A had to pay a tax per unit of output, his cost of production rises and thus, the private optimum now moves towards the social optimum. The amount of this tax, according to Pigou (1920) should precisely be equal to the marginal social cost of pollution per unit of output. Essentially the mechanism is that the externalities created due to the pollution are internalized and thus accounted for. This is shown in the diagram above. Measuring Quantity of output on the horizontal axis and Cost, Revenue and price on the vertical axis, it is shown under a perfectly competitive structure ( P = AR = MR) how imposing a Pigouvian tax can lead to the polluter producing at the social optimum rather than at the private optimum. Suppose initially, there is no such tax. The producer maximizes profits where MC = MR and that is the level of output identified as the private optimum. Since this output level causes some given damage to the environment, it also has a social cost associated with it. However, that damage is not internalized by the producer himself. The marginal social cost curve reflects this damage to society. The level of output corresponding to the intersection of the social marginal cost curve and the marginal revenue curve is the optimum for society. Thus, initially, the amount produced exceeds societies optimum by the distance (private optimum – social optimum). Now, if a tax is imposed on the per unit output of the polluter, his marginal cost curve shifts upwards as for every additional unit of output a higher cost has to be borne. There exists a particular per unit tax which shall move the polluters marginal cost curve exactly so that it intersects the marginal revenue curve precisely at the level of output corresponding to the social optimum. This shall be the point where the social marginal cost curve intersects the marginal revenue curve. The per unit tax that is able to achieve precisely this allocation is called the Pigouvian tax. It is precisely equal to the marginal externality for any given output level. Now, with the costs restructured, the private optimum coincides with the social optimum. In the diagram the distance o-a represents the Pigouvian tax. The shaded area represents the governments revenue from the tax. The advantages that a Pigouvian tax has over the alternative of establishing state dictated regulatory control on the amount of pollution permissible for any producer is essentially twofold. First, the Pigouvian tax actually provides the producer with an incentive to reduce pollution. Since due to the presence of this tax, every unit of pollution costs more, the profit maximization problem for the producer will incorporate the requirement of reducing these costs and thus reduce the amount of pollution. Secondly, Pigouvian taxes generate a revenue for the Government. So, there are twin dividends to be reaped. Not only is the pollution level reduced in aggregate, there is also a positive revenue generated. This revenue allows the government to cut down on other distortionary taxes that it may have imposed on other productive activities. The Pigouvian tax although conceptually very simple and appealing, does fall short on grounds of practical applicability and the main disadvantages are essentially manifestations of such practical problems. First and foremost, computing the Pigouvian tax depends upon information assuming which to be readily available may be unrealistic. The exact per unit cost structure of any producer may not be available to the government. Further, in the presence of market imperfections, the optimum amount of a Pigouvian tax is not equal to the marginal externality itself. It has been shown by Buchanon (1969) and subsequently by Barnett (1980) that under an imperfectly competitive industry that produces pollution as a byproduct, the optimum Pigouvian tax should lie below the social marginal cost of pollution. Thus, setting it equal to the marginal damage caused by pollution would be sub-optimal. Also, as argued by Ronald Coase (1960), the social optimum can be reached without intervention simply through the introduction of enforceable property rights, as often the incentives of the polluters and the individuals affected lead to private arrangements between them with either the producer paying the sufferer an amount for the right to pollute or the sufferer paying the polluter for the right to clean air. As a result the problem of externalities are internalized through such private resource transfers. However, for such an arrangement to attain social optimum, bargaining and transfer costs have to be insignificant. But even in the presence of positive transfer costs, such private transfers may take place which partially mitigate the effects of the externality. But if a Pigouvian tax has to be imposed in the presence of such transfers, or market imperfections for that matter, it has to take these into account and the computations become complicated and contingent upon a large base of perfect and complete information. Finally, the Pigouvian tax is associated with a deadweight loss which can be avoided if instead a regulatory framework is adopted. In the diagram below, this deadweight loss is shown. To conclude, what emerges is that a Pigouvian tax, in principle, is very appealing and a solution with a number of advantages to the problem of discrepancy between private and social optima in the presence of externalities. It is however, based upon information that is not readily available and its applicability is limited since to attain perfection all present taxes subsidies and transfers would have to be accounted for and replaced in the net by a Pigouvian tax. The easy solution of setting the tax precisely equal to the externality per unit of output is plausible and meaningful only in the absence of regulations and market imperfections. References: Barnett, A. H., (1980) “The Pigouvian tax rule under monopoly”, American Economic Review 70, 1037-1041. Baumol, W. J., (1972) "On Taxation and the Control of Externalities", American Economic Review 62 : 307–322 Buchanan, J. M., (1969) “External diseconomies, corrective taxes, and market structure”, American Economic Review 59: 174-177 Pigou, A. C., (1920) “The Economics of Welfare” Macmillan, London Read More