Curb Your Enthusiasm for Pigovian Taxes

Abstract: Pigovian (or "corrective") taxes have been proposed or enacted on dozens of harmful products and activities: carbon, gasoline, fat, sugar, guns, cigarettes, alcohol, traffic, zoning, executive pay, and financial transactions, among others. Academics of all political stripes are mystified by the public’s inability to see the merits of using Pigovian taxes more frequently to address serious social harms, some even calling for the creation of a “Pigovian state.” This academic enthusiasm for Pigovian taxes should be tempered. A Pigovian tax is easy to design—as a uniform excise tax—if one assumes that each individual causes the same amount of harm with each incremental increase in activity on the margin. This assumption of uniform marginal social cost pairs well with the limited information and enforcement capacity of government institutions. But when marginal social cost varies significantly, a Pigovian tax may not lead to an optimal allocation of economic resources. Focusing on carbon emissions, where the assumption of uniform marginal social cost happens to be reasonable, obscures this common design flaw. Broadly speaking, Pigovian taxes are likely to be the optimal regulatory instrument only when (1) the harm is (or is properly analogized to) global pollution, and where the harm does not vary significantly based on the source, or (2) the variation in marginal social cost is easily observed and categorized, as with traffic congestion charges. This straightforward insight has broad implications for how we design any targeted tax or subsidy. It explains why a carbon tax would work well, but some other environmental taxes would not. It explains why many food taxes would be ineffective in improving public health. It explains why most sin taxes raise revenue but do not change behavior. Pigovian taxes are, under certain conditions, a useful instrument of regulatory policy, but we should resist the temptation of a Pigovian state.