Pigouvian tax

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A Pigouvian tax (also spelled Pigovian tax) is a tax on any market activity that generates negative externalities (i.e., external costs incurred by third parties that are not included in the market price). A Pigouvian tax is a method that tries to internalize negative externalities to achieve the Nash equilibrium and optimal Pareto efficiency.^[1] The tax is normally set by the government to correct an undesirable or inefficient market outcome (a market failure) and does so by being set equal to the external marginal cost of the negative externalities. In the presence of negative externalities, social cost includes private cost and external cost caused by negative externalities. This means 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.^[2] Often-cited examples of negative externalities are environmental pollution and increased public healthcare costs associated with tobacco and sugary drink consumption.^[3]

In the presence of positive externalities (i.e., external public benefits gained by society that are not included in the market price), those who did not consent to be part of the market activity receive the benefit, and the market may under-produce. Similar logic suggests the creation of a Pigouvian subsidy to help consumers pay for socially beneficial products and encourage increased production to generate more positive societal benefits.^[4][5]

An example sometimes cited is a subsidy for the provision of flu vaccines and the public goods (such as education and national defense), research & development, etc.^[6][7]

Pigouvian taxes are named after English economist Arthur Cecil Pigou (1877–1959), who also developed the concept of economic externalities. William Baumol was instrumental in framing Pigou's work in modern economics in 1972.^[3]