Government Intervention: Taxation and Subsidies

Taxation and subsidies are two of the most important tools available to governments seeking to correct market failure. When negative externalities lead to over-production or over-consumption, a tax can raise the private cost to reflect the social cost, reducing output towards the socially optimal level. When positive externalities lead to under-production or under-consumption, a subsidy can reduce the private cost, encouraging greater output. The theoretical basis for these corrective measures was established by Arthur Cecil Pigou (1920) in The Economics of Welfare.

Key Definition: A Pigouvian tax is a tax imposed on a good or activity that generates negative externalities, set equal to the marginal external cost (MEC) at the socially optimal level of output. The purpose is to internalise the externality — to make the polluter pay the full social cost.

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Types of Tax

Before analysing corrective taxes, it is important to understand the different types of indirect tax: