Pigovian taxes aim to internalize externalities from "summary" of Public Finance by Harvey S. Rosen
Pigovian taxes are designed to correct market failures that arise from externalities. An externality occurs when the actions of one individual affect the well-being of another individual, without compensation. For example, pollution from a factory imposes costs on nearby residents, who must breathe polluted air or drink contaminated water. Because the polluting firm does not bear these costs, it has no incentive to reduce pollution to the socially optimal level. Pigovian taxes aim to address this problem by taxing activities that generate negative externalities, such as pollution. By levying a tax on the polluting firm equal to the cost of the external harm it causes, the government can internalize the externality. The tax increases the firm's costs, leading it to reduce pollution to the socially optimal level. In this way, Pigovian taxes ensure that individuals and firms take into account the full social costs of their actions when making decisions. This helps to align private incentives with social goals, leading to a more efficient allocation of resources. Pigovian taxes can also be used to correct positive externalities, where the actions of one individual benefit another without compensation. For example, education generates positive externalities by increasing the productivity of workers and creating spillover benefits for society as a whole. By subsidizing education through a Pigovian tax credit, the government can encourage individuals to invest in education to the socially optimal level.- Pigovian taxes play a crucial role in improving economic efficiency by internalizing externalities and aligning private incentives with social goals. By taxing activities that generate negative externalities and subsidizing activities that generate positive externalities, the government can ensure that individuals and firms consider the full social costs and benefits of their actions. This helps to promote a more efficient allocation of resources and improve overall societal welfare.
