Pigovian taxes (updated)

In recent years problems such as pollution and global warming have resulted in a renewed interest in issues to do with Pigovian taxes. For example, it is becoming increasingly common to see calls for the addition of Pigovian taxes on the price of petrol. A number of prominent economists, lead informally by N. Gregory Mankiw, from all parts of the political spectrum have made calls for petrol taxes as a potential means of dealing with unpriced externalities. Mankiw has aggregated these concerns in his calls for a "Pigou Club" of economists who identify themselves by their support for a petrol tax.

In a draft paper, Finding the Right Pigou Tax in a World of Imperfect Coasian Bargains (scroll down to find the paper), to be given at the upcoming 2008 International Society for New Institutional Economics (ISNIE) meetings in Toronto, John VC Nye, of George Mason University, calls into question the economic justification for Pigovian taxes. The abstract of his paper reads

This paper calls into question the economic justification for Pigovian taxes and argues that existing empirical work is inadequate to justify the standard policy recommendations. In particular, it calls into question claims that the identification and measurement of a Pigovian externality is a sufficient condition for determining the optimal level of the tax. A claim about the optimal Pigou tax is a joint claim about the size of the externality and about the optimality of observed outcomes, not just the externality. Measuring the size of the observed Pigovian externality – even if done perfectly -- is not a reliable guide to the proper level of the Pigovian tax because in a world of efficient transfers we will still observe some externalities. Hence the debate about externalities should be about whether those compensating factors exist and not about measuring the externality itself. Contrary to received wisdom, we do not have strong evidence that any positive gas tax in the current economy is advisable, let alone information about what its level should be.

Nye goes on to explain

The basic arguments can be outlined as follows:

First, the benchmark Coasian case: In a world of costless bargaining, well-defined property rights, and very low transactions costs, the various parties will negotiate till a jointly maximizing outcome is reached. No taxation is necessary or desirable.

Second, even in a world of positive transactions costs, some Coasian transfers may take place which partly mitigate the harm of the externality. Unless one can fully account for all these transfers – whether conscious or accidental – any estimate of an appropriate Pigovian tax based solely on the size of the Pigovian externality that is measurable will clearly overstate the optimally efficient tax level.

Third, in the presence of regulations (at any level from that of the local community up to the federal government) that have bearing on the supply of the externality causing activity – even if not directly tied to the externality itself – we will need to estimate how different the level of the activity actually is from the hypothetically efficient level. Absent such an estimate, simply knowing the size of the externality itself will give us no clue about the appropriate tax nor its optimal level.

Fourth, even in a strictly Pigovian world in which both the possibility of Coasian bargains and the indirect effects of regulation on the equilibrium supply of the externality-producing good are simply assumed away, the optimal Pigovian taxes are likely to be lower than the standard Pigovian rate if there are other taxes in the economy (Bovenberg and Goulder, 2001). That is, the Pigovian tax rate estimated in a partial equilibrium setting is likely to be supraoptimal in a general equilibrium setting in which a variety of distortionary excises already exist – even if those taxes were not explicitly designed to cope with externalities. Furthermore, taking into account regulations which are substitutes for Pigou taxes – even if indirectly – further moves the optimal tax level away from the standard Pigou solution and makes it likely that applying a straightforward Pigovian tax in addition to existing taxes and regulations is inefficient and even counterproductive.

The single major problem is that the applied Pigou tax literature concentrates on the presumption that TAX = MARGINAL EXTERNALITY or Pigou Externality (PEX). But in actuality what we need to know is the optimal quantity of the good or activity that produces the externality. Absent detailed information about both regulatory distortions and private Coasians transfer, knowing the size of PEX gives us NO clue as to the size of the optimal Pigou tax.

(HT: Division of Labour )

Update: There are interesting comments on the Nye idea in The overestimation of Pigovian taxes posting at The visible hand in economics.