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Pigovian Taxes - Joining the Pigou Club

Promoting Economic Growth and Reducing Externalities


Like Dr. Greg Mankiw, I am also a big fan of Pigovian taxes. He quite rightfully points out that they "allow us to correct market failures without heavy-handed regulations, while raising government revenue so we can reduce more distortionary forms of taxation." So like Mankiw, I'm a supporter of the aims of the Pigou Club.

What are Pigovian Taxes

A pigovian tax is a tax placed on a negative externality to correct for a market failure. For example, a factory does not take financially take into account the damage their emissions cause to the air, since there is no market for air pollution. By imposing a Pigouvian Tax a government can artifically create a cost for such activity - ideally a cost equal to what the price would be had a market for such activity existed. In a country like Canada with socialized medicine, the cigarette tax atcs as a Pigovian tax - it (more than) raises the revenue necessary to offset the expense to the health care system generated by smoking.

Why I Support Pigovian Taxes

One of the uses of taxes is to discourage activity that has negative externalities, or we believe is otherwise economically/socially harmful. That's why these 'sin' taxes exist - they discourage people from smoking and drinking. It's also argument often put forward by those in favour of marijuana legalization - that a better and more cost-effective way of detering usage would be to legalize marijuana and tax it rather heavily.

These taxes also raise revenue for the state. In 2004-2005, the Canadian government collected $16.7 billion in "other" taxes, which were largely Pigovian taxes such as energy taxes and excise taxes on cigarettes and alcohol.

Since taxes deter the activity that is being taxed, then why in the world would we ever tax income? Don't we want to encourage hard work and entrepreunership? Yet in Canada, over 45 percent of federal government revenue comes from personal income taxes and 15 percent comes from corporate income taxes.

I've been rather hard on the supporters of the FairTax, but they have the right idea. Taxing activities we wish to encourage (work) does not make a great deal of sense when we can tax acitivities we are not as interested in promoting (consumption). The FairTaxers take it too far - the amount of revenue needed to finance all the government programs we value cannot be generated by simply a consumption tax alone. But the basic idea is sound.

I live in the Southwestern Ontario region of Canada, an area with perhaps the poorest air quality in all of the country. Each year we have a record number of smog days. Wouldn't it make sense that we try to discourage the use of electricity generated from coal and the use of fossil fuels? Yes, this would have negative effects on the economy in isolation, but if we used the revenue generated from such a tax to lower employment insurance premiums or income tax rates, it's likely that the net economic effect would be positive.

Yes, we can go too far with Pigovian taxes. For instance, we could charge a level of Pigovian tax far in excess of the damage caused by air pollution. But can anyone claim that we have the current optimum level of work? The optimum level of investment? The optimum level of savings? If we are forced to overtax something, and we are given the cost of running government, air pollution seems like the best place to start.

It's true that Pigovian taxes tend to be regressive in the sense that they cause the poor to pay a higher proportion of their income on them than the rich. While this doesn't seem to bother many when we discuss raising the taxes on cigarettes, the overall effect of increased use of Pigovian taxes would cause a level of regressivity that Canadians are uncomfortable with. This regressivity effect can be eliminated through bundling Pigovian taxes with some form of negative income tax, like the U.S. Earned Income Tax Credit, such that average tax rates remain progressive.

With so many advantages, I full-heartedly support the increased use of Pigovian taxes in Canada or any other country. While I'm not a famous well-respected economist like Dr. Mankiw, I would still like to ask for a membership into his club.

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