Pigovian Taxation as a Means of Reducing Carbon Emissions
Economic equilibrium is reached when demand and supply are equal. Market equilibrium is similar, with prices of goods and services canceling each other out. Loyal to the definition of “equilibrium,” this state will not change unless one of the contributing factors, such as supply or demand, changes first. Economic equilibrium is largely theoretical, but it’s an ideal which economic policymakers strive towards. Some market inequalities are countered with taxes or subsidies. A notable method is Pigovian taxation – a “sin” tax developed to discourage a specific behavior through taxation.
Pigovian taxes were theorized to correct negative externalities by imposing an additional marginal cost on a producer. By penalizing an unfavorable behavior, economic policymakers believe that the tax system would discourage or limit the activity which causes the negative externality. Negative externalities occur when a producer does not pay the full cost of a market decision, and the excess cost, often not measured in currency, is absorbed by society. This creates market inefficiencies, as there is a gap between a producer’s costs and the costs imposed on society because of the producer’s decisions. An example may be a person who has decided to paint their house a vibrant color in an upper-class neighborhood: the homeowner bought the paint and enjoys their lime green house, but their neighbors dislike the fact that the oddity has a negative impact, aesthetically or otherwise, on the homogeneous community.
Pollution is often cited as a practical example of the potential of Pigovian taxation. Suppose a steel mill were located in a particular town. During steel production, air and water become heavily polluted, the biodiversity around the mill decreases, and a formerly rural town is impacted by sudden industrialization. The pollution created by steel production has no affect on the company or its profits, but affects the citizens of the town, and can be labeled as a societal cost. Theses costs – air and water pollution, lessened aesthetic appeal, decreased biodiversity, noise and industrial development – are costs absorbed by citizens, and are therefore negative externalities. In response, the government may levy a Pigovian tax against the steel company equal to the societal costs, or negative externality. This may encourage the steel company to decrease its overall output or improve pollution containment efforts.
Though the theory behind Pigovian taxes is solid, its application is more difficult. To be effective, the tax must be set at an adequate level to cancel effect of the negative externality. In an insulated governing environment, this action would favor of society. However, current governments are lobbied by producers of negative externalities, most notably big oil. In a Pigovian taxation system, this could result in lower taxes that favor the producer and reduce the tax’s effect. Conversely, special interests may lobby for such high taxes that production is adversely affected, negating the potential positive effect of the Pigovian tax due to the overall negative effect on the economy.
Before the 1970’s, Pigovian taxing has met some applicable success in the US, but was soon replaced by a more profitable system of “pollution rights.” Policymakers prefer this system because polluters don’t lose profits by taxation, and may even earn extra profits by selling their unused pollution rights to a needy polluter. On the smaller scale, Pigovian taxes have been added to everything from cigarettes to soda, and have been proposed to be the structure behind a counter-pollution Carbon tax.
Since the G20 proposed Kyoto Protocol, there is a worldwide movement involving law-binding pollution goals. A more prevalent idea to reach these goals is a Pigovian tax on carbon production. Carbon taxing is directed at the “producer” of the negative externality, or fossil fuel industries which contribute most heavily to carbon emissions. By taxing carbon emissions, Carbon-emitting industries would face an extra marginal cost. Industries would be forced to either take in less profit, or slow their production of
carbon emissions to avoid these costs. By interfering with the fossil fuel industry, production and competition would slow, and may encourage more infantile energy industries, such as solar, wind, and geothermal, to grow with by alleviating pressure from established competitors. Currently, a growing number of countries, including many EU representatives, Australia, and Canadian provinces impose some form of carbon tax, or have introduced an Emissions trading system.
As world markets become more complex and our understanding more thorough, solutions are offered to balance societal inequalities. Pigovian taxes discourage the taxed behavior by increasing the cost of the action. The taxed entity may alter its behavior to avoid the taxes. When this is a large, profitable company, this slowed production relieves smaller organizations of a competitive burden, allowing them time to grow stronger and more profitable. In these ways, Pigovian taxes can, in time, strengthen markets by increasing the number of producers or suppliers. Broader uses of the Pigovian system are being implemented, in the form of Carbon taxing. Classic Pigovian taxation has been successful, but only time will tell if newer Pigovian models will have the same fate.
*edit 2/17/2012: same content, better wording