climate change economics

What is Pigovian taxation?

Following posts on land value taxation, income tax and the citizen’s income, here’s another recurring idea in new economics – . It sounds like something out of Animal Farm. (Its alternative spelling, Pigouvian, might have associations of its own.)

Foolishness aside, Pigovian taxation is named for Arthur Pigou, a British economist who explored the role of externalities. Writing in the 1920s, he described how business activity could have unintended and unpriced effects in society. Some of them might be positive, with everybody benefiting at the expense of the business. Others might be harmful, with the business benefitting at society’s expense.

Here’s a trivial example of each from my childhood in Antananarivo. When we used to drive into town, my favourite part of the short journey was when we drove past the coffee roasters on the Route Digue. There was the most wonderful smell that wafted across the highway. We didn’t pay anything for that, it was just a happy effect of the roasting business – a positive ‘uncharged service’ as Pigou called it.

In another part of town there was a community of stone-masons. They broke off chunks of rock from a cliff-face and then chiselled it into blocks by hand. Across that whole district there was the sound of hammering and chipping from dawn to sunset, broken only occasionally by the boom of dynamite blasting instead. It was incessant, noisy, and had a way of burrowing into your brain. Nobody was compensated for the noise and dust from the quarry, that was just an unfortunate effect of the business – an ‘uncharged disservice’, or negative externality.

Pigou was concerned with bigger matters than the smell of coffee roasting, but along the same principles. One of his concerns was alcohol. It’s a legitimate business, but the abuse of alcohol leads to all kinds of social problems, from anti-social behaviour to addiction and liver disease. Society picks up the tab for those problems through the police and the National Health Service. A tax on alcohol prices in the cost of those externalities so that they’re paid for by retailers and consumers of alcohol rather than society in general. We see a similar approach with cigarettes, gambling, and fossil fuels.

This form of taxation isn’t new, and plenty of countries have had taxes that could be described as Pigovian, even before Pigou described the theory. We’re hearing more about it at the moment because Pigovian taxes have come into their own with climate change. As Lord Stern says, from an economics perspective climate change can be described as a giant market failure – the failure to put a price on carbon. Correcting market failures are exactly what Pigovian taxes are supposed to do.

The most obvious form is a carbon tax, like the one Australia has recently brought in. Plenty of other countries have them too. The Scandinavian countries have operated carbon taxes for 20 years. There’s little hope for a carbon tax in the US anytime soon, but local areas and states are free to bring in their own, like Boulder Colorado or the San Francisco Bay area.

There are other routes to the same goal of course. You can legislate strict limits on carbon or create carbon markets under a cap and trade system, but taxes have several benefits – the polluter pays, a revenue stream is generated from something that was formerly a problem, and business incentives are created to reduce carbon, all without heavy handed legislation.

There are problems associated with Pigovian taxes. Externalities are notoriously difficult to price, and some argue that they are mildly regressive. But they’re a tool in the box for creating a fair and sustainable tax system, and one of the most obvious responses to climate change. We should expect to see more of them in future – even .

8 comments

  1. “As Lord Stern says, climate change is at heart a giant market failure – the failure to put a price on carbon. ”

    Do you agree with Lord Stern? Is this what climate change is “at heart”? Is calculative reason alone (in the absence of any broader practical reason) sufficient to the task of addressing it?

    1. Climate change is a giant market failure, but that’s by no means all it is or the only way of looking at it. As an economist, Lord Stern sees a market problem and recommends market-based solutions, but that’s a very limited view.

      Since this post is about an economic solution, I’m happy to cite an economist’s definition of the problem, but you’re right to question how far that goes. There are political, psychological and spiritual perspectives that are ultimately more important.

  2. We did not put a price on carbon because we thought we could steal it from the earth and those with small voices whilst many gained at the expense of others and the rest would quietly participate and benefit, in ignorance. Now that it is biting us all back we think we must take it seriously. Do we really know how to? Optimism is certainly required Jeremy and you are the man for the job. Keep up the good work!

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