Corrective Taxes and Subsidies

Instead of regulating behavior in response to an externality the government can use market-based policies to align private incentives with social efficiency. For instance as we saw earlier the government can internalize the externality by taxing activities that have negative externalities and subsidizing activities that have positive externalities. Taxes enacted to deal with the effects of negative externalities are called corrective taxes. They are also called pigovian taxes after economists Arthur Pigou (1877-1959) an early advocate of their use. An ideal corrective tax would equal the external cost from an activity with negative externalities and an ideal corrective subsidy would equal the external benefit from and activity with positive externalities.

Economists usually because they prefer corrective taxes to regulations as a way to deal with pollution because they can reduce pollution at a lower cost to society.

The regulations would dictate a level of pollution whereas the tax would give factory owners an economic incentive to reduce pollution.

Most economists would prefer the tax. They would first point out that a tax is just as effective a regulation in reducing the overall level of pollution. The EPA can achieve whatever level of pollution it wants by setting the tax at the appropriate level. The higher the tax the larger the reduction in pollution. Indeed if the tax is high enough the factories will close down altogether reducing pollution to zero.

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