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The Insufficiency of Pigovian Taxes

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12/2/2013 11:46:06 AM
Posted: 2 years ago
In his critique of Pigovian taxes (i.e. taxes equal to social cost, meaning costs not borne by the producer), Ronald Coase inadvertently laid the groundwork for an argument for super-Pigovian taxes (i.e. taxes higher than social cost). His critique centered around the victim's contribution to marginal social cost (MSC), for instance living in a polluted area (as opposed to living in a less polluted area or simply killing oneself), a previously ignored factor. If, for example, a pollution tax's reduction of pollution causes an increase in population that outweighs its reduction of the pollutant's MSC per person, the result will be a higher total MSC and thus a higher Pigovian tax.

What's wrong with that, the reasonable reader may wonder. Well, Coase was of the opinion that it would be cheaper for the new residents not to live there than for the polluter to cease polluting; if not, they would have simply paid the polluter not to pollute (ignore the impracticality and the scent of a protection racket). That's called Coasian bargaining, but what Coase didn't realize was that it's not incompatible with Pigovian taxes: if Coasian bargaining really works, then the Pigovian taxed polluter, for example, will pay the new residents not to live there (he's of course at least as likely to have the means to compensate them as they him) and thus not increase his tax burden, and efficiency will reign.

Still, the Coasian perspective is useful, for how would Coasian bargaining in the context of a saleable right to a clean environment, for example, differ from a Pigovian tax?

First of all, the price (of pollution permits) would be marked up, as for any commodity for any degree of monopoly. By contrast, the price equation under Pigovian taxes is two-termed: P=MPC*(1+k)+MSC, where MPC is marginal private cost and k is the average mark-up for the whole economy; as the producer pays mark-ups on private costs but not social costs, the market is still distorted in favor of dirty goods (i.e. goods with high MSC/MPC) at the expense of clean goods. By taxing externalities at MSC*(1+k), instead of the Pigovian MSC, and reducing the income tax (or other ad valorem tax) so that the total tax burden is unchanged, the distortion in favor of dirty goods could be corrected without further distorting the labor-leisure interchange.

That is, unless we consider the other difference between Coasian bargaining and Pigovian taxes, which is that the transaction is horizontal in one case and vertical in the other. Pigovian taxes are thus equivalent to Coasian bargaining (in the context of victims' rights) plus taxation of victims. Some who would be happy to reside in a polluted area if they were compensated MSC*(1+k)/n, n representing population, would not if the money went instead to the government (particularly a higher-level government).

So while a Pigovian tax of MSC*(1+k) would achieve the same (initial) reduction of pollution as its Coasian equivalent, it would fail to achieve the same increase in population. The consequence of the lower increase in population would of course be a lower increase in MSC (taxed at a rate of 1+k), and thus a lower secondary reduction of pollution. The only way to correct that would be to earmark the tax for the particular social cost (e.g. pay for transportation, lighting and healthcare with taxes on factories in crowded neighborhoods, to use Pigou's example).

[Note: in making these observations, I have had to accept many neo-classical assumptions, whereas in reality markets don't work and no amount of ex post tinkering can change that].