The Pigou Problem: It Is Difficult to Calculate the Right Tax in a World of Imperfect Coasian Bargains

By Nye, John V. C. | Regulation, Summer 2008 | Go to article overview
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The Pigou Problem: It Is Difficult to Calculate the Right Tax in a World of Imperfect Coasian Bargains

Nye, John V. C., Regulation

In recent years, there has been a revival of interest in Pigovian taxation, especially for dealing with the problems of global warming and pollution. A number of prominent articles have variously argued for additional Pigovian taxes on gasoline. For instance, Ian Parry and Kenneth Small offered indirect estimates of the relative size of the externality per unit of gasoline consumed in a 2005 American Economics Review paper examining gas taxes in Great Britain and the United States. The following year, Aaron Edlin and Pinar Karaca-Mandic published a paper in the Journal of Political Economy that calculated the accident externality from driving. More recently, a number of prominent economists from across the political spectrum have issued calls for Pigovian taxes on gasoline as a potential means of dealing with unpriced externalities. Harvard's Gregory Mankiw has informally aggregated those concerns in his calls for a Pigou Club of economists who identify themselves by their support for a gasoline tax. On his website, Mankiw argues for an additional $1-a-gallon tax on gasoline in the United States, implemented over a 10-year period.

This article questions the economic justification for these Pigovian taxes and argues that existing empirical work is inadequate to justify such a tax in the standard neoclassical framework. 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 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.

Even in a world with compensating transfers and regulations, the observed amount of the externality (e.g., pollution) is unlikely to be zero. Any tax calculation that is determined using the size of the measured externality but that does not consider all regulations and transfers affecting equilibrium will not tell us what the optimal tax should be. Any tax recommendation requires empirical work that is not undertaken in any of the cited papers. A tax imposed without such calculations may well be superfluous and inefficient.


In his classic 1960 Journal of Law and Economics article "The Problem of Social Cost," Ronald Coase questioned the reliability of using Pigovian estimates to craft real-world regulation. His core argument is usually stated thus:

* In a world of costless bargaining, well-defined property rights, and very low transactions costs, the various parties will negotiate until a jointly maximizing outcome is reached. No taxation is necessary or desirable in this world.

However, it is not often understood that his argument is relevant even when transactions costs are positive. We can extend his reasoning to see how it bears on the problem of taxing externalities:

* Even in a world of positive transactions costs, some Coasian transfers may take place that partly mitigate the harm of an externality. Unless the Pigovian tax collector can fully account for all those transfers, any estimate of an appropriate tax based solely on the size of the externality will clearly overstate the optimally efficient tax level.

* In the presence of regulations (at any level of 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 the difference between the real-world level of the activity and the hypothetically efficient level of the activity.

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The Pigou Problem: It Is Difficult to Calculate the Right Tax in a World of Imperfect Coasian Bargains


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