Thursday, April 12, 2007

The Pigovian Tax

In my post from two days ago, Limitless Harm Morality, Blacksun posted a comment that brought up the concept of a ‘Pigovian tax’ . Some people may know of this as an ‘externalities tax’. It is a tool that the government can use to help ensure that one group of people do not prosper by, effectively, robbing another group of people of life, health, and property without some form of compensation.

The Pigovian tax has a strong moral foundation. There are those who argue against its use. For the most part, they can be shown to be people who want to promote a society in which killing and otherwise harming others for profit remains legal.

The Problem of Externalities

On the whole, markets tend to do a far better job of promoting social welfare (making the world a better place than it would otherwise have been) than governments. Whenever powers are entrusted to the government, we are far more likely to find legislators auctioning off those powers to the highest bidder, than using them for the public good. Legislators tend to be the agents of those who buy them a seat in Congress, and the average citizen typically lacks the resources to participate in the bidding.

In earlier years, people may be counted on with a reasonable degree of certainty to vote their interests. However, the modern age, where those with wealth can use the science of marketing and manipulation to confuse people as to what their interests are, even this is far less assured than it once was.

‘Markets’, understood as these machines of social welfare, require that certain rules be in place and enforced. When these rules are violated, markets are distorted, and a ‘misallocation’ of resources results.

One of these rules is that each person pay his own way. If somebody has open access to your bank account to buy whatever he wants, you would expect that person to buy things that he would judge ‘not worth the cost’ if he were spending his own money. Assume he sees a television set that costs $1000. It is really worth only $500 to him – he would not pay more than that. However, since he is using your credit card, it costs him nothing. He buys the television set worth $500 to him, but you are out $1000.

Let’s say, I barbeque a pig in my back yard with the intention of selling off the meat for a handsome profit. However, my activity puts sparks in the air, which set your house on fire. The loss of your house is a ‘negative externality’. It is a cost of my doing business, but it is a cost that I can shift onto somebody else. Because I can force others to pay those costs, they do not affect the profitability of my barbequed pork business.

In terms of social welfare, this is economically inefficient.

In economic terms, these ‘costs that are passed on to others’ are called negative externalities.

The paradigm example of a negative externality is pollution. I engage in some activity that is ‘good for me’ in that I make a profit. My factory puts chemicals in the air or water, which causes cancer in people who live downwind or downstream. The increased number of people dying of cancer is a part of the overall social cost of my doing business. Yet, I do not pay those costs. Therefore, I have no reason to stop doing business.

For all practical purposes, I am living off of the profitability of robbing others of their lives and their health; gaining personal wealth, while I make the world a worse place than it would have otherwise been.

It is also possible for a ‘Pigovian tax’ to also deal with positive externalities. It does so in the form of subsidies. For example, when a person obtains an education, he does not obtain all of the benefits of his actions. His education will tend to produce ‘positive externalities’ in that his better-informed decisions will benefit people other than himself. So, it makes sense to subsidize education as a way of internalizing some of those positive externalities.

The Value of the Pigovian Tax

The Pigovian tax is a mechanism that theoretically puts an end to this type of theft. It is a mechanism that forces polluters to pay for the harm that they do to others. The polluters pay a fee for every unit of pollution that they create, and that money goes to compensate the victims for the losses that they suffer. This way, the social costs of pollution are added to the cost of doing business. If the business does not produce enough social benefit to overcome the social costs, then the business ceases to exist. If the business can still make a profit, at least it does not leave a pile of innocent victims in its wake.

Some argue that it is not possible to compensate a person for the loss of a life. However, we trade other things for life all the time. There is a long list of things each of us could do to extend our lives that we do not do. We do not do these things because we consider the benefits in terms of an extended life to be less than the cost. Another piece of evidence supporting this same conclusion is the mere fact that we do not devote all of our resources to saving lives. We spend money on sports, movies, dining in restaurants, and a long list of other activities that do not ‘save lives’. In short, we trade other goods for life all the time. The idea that life is of infinite value is simply false, and no sound social policy can be built on false premises.

In addition to promoting justice (in that people are not permitted to find profit in robbing others of life, health, and well-being), the Pigovian tax makes economic sense. It makes non-polluting and less-polluting options more competitive in the market place. In other words, it ends the subsidy that the polluting industry has had by being allowed to force its costs of doing business onto innocent third parties.

The Pigovian tax also promotes innovation right where we need the most innovation. When businesses have to suffer the costs of pollution, they have a reason to invest in finding ways to stop that pollution. This enhanced investment in forms of production that produce less or no pollution benefits everybody, including the business, who will no longer have to pay the tax.

Arguments Against the Pigovian Tax: Economic Harm

The first argument we hear against the Pigovian Tax is that it is bad for the economy.

Consider, for example, a Pigovian tax on carbon to pay for the costs of global warming. This raises an outcry that the higher price of energy means fewer jobs and other forms of economic destruction.

This is utter nonsense. The Pigovan Tax is used in situations where somebody is going to suffer a loss.

Let’s look at the example where I have my pork barbeque, and I end up burning down your house. The economic destruction here is the loss of your house. The Pigovian tax only answers the question, “Who pays?” Without the Pigovian tax, you suffer the loss of your house, and must either buy a substitute or go without. With the Pigovian tax, I pay for the cost of your house. The tax money goes to compensate you for your loss.

Either way, the economic destruction is caused by the burning down of the house, not by the tax. The tax only determines who pays for that destruction – the victim, or the person who caused harm for profit.

Arguments Against the Pigovian Tax: Imprecision

In Blacksun’s comment, he mentioned people who tried to insist that the tax could never be used because we lack the ability to determine the precise value of the tax.

There are three problems with this objection.

The first problem is that it commits the fallacy ‘argument from ignorance’. Thousands of years ago, people made the amazing discovery that ‘zero’ is a number. It is considered one of the great advances in mathematics. Taking this into consideration, we can see that this objection actually says, “We lack the ability to determine the best level for a Pigovian tax; therefore, the best level for a Pigovian tax is zero.”

If we lack the ability to determine the best level for a Pigovian tax, then we also lack the ability to determine that zero is the best level for a Pigovian tax.

If we truly are as ignorant of the best level for such a tax as this argument assumes, then a tax of $1.00 per unit is just as likely to be the right level as a tax of $0.00; and no argument can be given for preferring one option over the other. Any argument that $0.00 is better than $1.00 will violate the original assumption that we cannot determine which value is best.

The second problem is the inference, “If we cannot tell precisely what the effects of our action will be, then we should do nothing.”

I cannot tell precisely what the results of writing this essay will be. I have certain hopes, but I have no guarantees. If this inference were valid, then I should not write this essay until I was certain of the results. In fact, I should not do anything unless I was certain of the results. However, I can never be certain of the results of anything that I do. Therefore, this argument seems to suggest, I should do nothing.

Unfortunately, I also cannot predict the results of doing nothing, so I can’t do that either.

It seems as if I am doomed. I can’t do something. I can’t do nothing. In both cases, the results are equally unpredictable.

This argument reveals the absurdity in the idea, “If you cannot tell precisely what the effects of our actions will be, then we should do nothing,” We have to act in the face of uncertainty. That is a law of nature. Given this fact, what we need to ask is, “Allowing for uncertainty, which of our available options has the best chance of producing the best results?”

The third problem with this argument is the assumption that we cannot know if we are doing good. Even if we cover the most obvious costs of pollution, and leave the less obvious costs uncovered, we would be doing obvious good. If a factory increases the cancer rate in a community from 10:1000 to 20:1000, then we know to collect the costs of 10 cases of cancer from the company. We do not know exactly which of the 20 patients to give the money to. Perhaps the best option is to pay for half of each person’s bills. Either way, the costs of doing business is paid by the company causing the cancer, not the people who get cancer.

A third argument is that if we permit legislatures to implement these taxes that political lobbying will distort the tax to favor special interests. Once again this ignores the fact that those special interests are already at work to set the externalities tax at zero.


If we want to find an explanation for why people use these arguments against a Pigovian tax, we are not going to find our answer in the strength of these arguments. The objections are so absurd that nobody could believe that they made sense unless the person wanted to believe that they made sense.

That shows us the type of person we are dealing with here.

We are dealing with people who have no moral qualms against profiting by killing and otherwise harming others. In some cases, their victims number in the hundreds of millions. However, rather than worry themselves over the harm they may be doing to others, they grasp at whatever straws float within reach for a chance to continue business as usual.

If somebody offered a million dollars to push a button, and said that scientists have reason to believe that pushing the button would take the lives and health of a million people, what type of person is it who would take the money and press the button?

Should we be working to fill our society with such people?

When we reward these people who harm others, when we protect their profits and give them a seat at the head of the economic and political table, we are telling our children, “When you grow up I want you to be just like him. If you have an opportunity to get a million dollars, I don’t want you to give a thought to the people you might hurt. I want you to take that money regardless of the consequences.” You are giving the same message to everybody else’s child. In such a world, do not be surprised if it is more likely that your child will become one of the victims of such a person than somebody who successfully victimizes others.

That is, if this is what you really want.


Anonymous said...

If a business producing plastic flamingos to put on your lawn was releasing dangerous chemicals that cause 10 people to die every year, could you honestly say that taxing them is the best policy? Lets say that some economists do a survey and they determine that citizens are willing to pay $500 to save the life of one person, so those 10 lives are "worth" $5000. But the plastic flamingo industry is "worth" $50,000, and preventing them from using those chemicals would shut down their business.

I think the only sane answer here is shut them down! Sure you could tax them and make them internalize the $5000 cost of killing people, and then they'd kill maybe 8 people instead of 10 or something.

But I think that one human life is worth more than a lot of the trash that our economy produces. People may value that trash more, but they're wrong.

We have to draw the line between what violates peoples' rights and what is simply imposing a burden on them. Taxing a club for making loud music that disturbs the surrounding area might make sense, for example. Loud music is a true negative externality. But if I go around killing people for profit, thats murder, not an externality.

Martin Freedman said...

Mike h

I disagree wiht your fundamental point summed up in your last sentence.

"But if I go around killing people for profit, thats murder, not an externality."
No, if one goes around killing people for profit, that is also murder as well as a negative externality. This is a key point. The negative externality does not disappear but is undeniably worse when comparing,say, noise pollution versus loss of life due to chemical poisoning. If, as I think we both agree, murder for profit is abhorrent and we want a society that can at least minimise it if not eliminate it, then a Pigovian tax on the chemical side effects of Plastic Flamingo production will serve that purpose more effectively than any other.

The question becomes when, in addition to using an externality tax, it is appropriate to ban something (in which case an externality tax is not needed, but that is just a consequence of this specific alternate policy and not a sufficient or necessary relation in general). As, I think Alonzo has implied in many of his other posts, people and businesses should be held responsible and pay the consequences of the harm that they do to others, then there seem to be two related systems of punishment - fines and prevention of trade on business versus fines and prevention of liberty on persons.

If there is a means of deciding that the operators of the Pink Flamingo business are murdering for profit, then they can and should be prosecuted for that as persons. In the meantime, Alozno has argued, and I agree, that the most efficient method that prevents such situations occurring is a Pigovian tax.

Martin Freedman said...

Just wanted to clarify that I do not regard a Pigovian tax as a fine. The first is a means to help make markets efficient by ensuring the appropriate parties bear their own costs and the latter is to discourage a party from transgressing whatever rules of that market legally apply.

Alonzo Fyfe said...

In any policy, there are instances in which the costs of doing something exceed the benefits.

Let us assume that there is an industry that produces $100,000 worth of externalities. However, the bureaucracy to collect and distribute a Pigovian tax would cost the government $1,000,000. This is a case in which it is literally true that "the cure is worse than the disease."

At the same time, if we have reason to be certain that a Pigovian tax would close down an industry, prudence suggests simply closing down the industry. For example, governments could have gone through the effort of putting a Pigovian tax on chemicals that damaged the ozone. However, such a tax would quite obviously make it economically unfeasible to use those chemicals. The things they were being used for were not that important and inexpensive sustitutes were already available. Given these facts, prudence does suggest an outright ban.

An outright ban on carbon dioxide or sulpher dioxide, for example, would be far too costly.

These, then, describe two boundary conditions for using a Pigovian tax. The value of the externalities we can correct for must exceed the cost of the bureaucracy to enforce the tax, and the externality-generating activity must be one that can survive the tax.

Anonymous said...


I understand that in a sense, murder for profit is "imposing a cost on another person," so technically yes, it is an externality. What I object to is CALLING it an externality. "Externality" has the connotation of not being very serious: simply internalize the cost and that makes everything okay. By calling murder for profit an "externality," you're helping to make it less serious of an issue than it is.

By viewing murder for profit as an externality, that already framed the issue for you as "something to be minimized." No, its something to be eliminated if possible! There's a difference in meaning. Of course the effect of trying to eliminate something is to minimize it, but if you set you're goal as "minimization" that communicates a weaker message than the goal of "elimination."

Its possible to eliminate the murder by shutting down the plastic Flamingo industry. My point is that the plastic Flamingo industry, like many industries, is fairly worthless when compared to the value of a human life. We need to keep our priorities straight: producing plastic junk should be last on our list, and preventing murder should be near the top. Viewing this as an externality issue muddles things and confuses our priorities.

How can you have a combined policy of a murder for profit tax and prosecution for murder for profit? That's a contradiction. One policy says "you must pay this much if you want to kill people" and the other one says "you may not kill people."

Anonymous said...

We constantly live with such contradictions.
Show me a major smuggler of any restricted substance who has gone to jail for smuggling, and I almost guarantee he also is in jail for income tax evasion.
Selling drugs is illegal, but if you do sell drugs you have taxable income from it.

Martin Freedman said...

Mike H

I was trying to make a distinction between an externality tax and murder-for-profit. The notion of a ban I was implying was like a criminal sentence for a business, when, as Alonzo correctly pointed out, it is really (or can be) a boundary condition for the real (full-cost) viability of a business.

I was not arguing for a murder-for-profit tax at all. I was alluding to the idea that you cannot hold a business fully responsible for murder or manslaughter as one does with persons and so it is the individuals controlling the business that should bear the consequences for that.

And the means to minimise whether or not the question of murder or manslaughter, as a consequence of a business's normal activities, comes up in the first place, a Pigovian tax, with real world boundary conditions, is currently the most effective means we know to achieve this.