1. A pollution tax aims to internalize some of the external costs of pollution by increasing the marginal private cost for suppliers. 2. The tax revenue generated could be used to address other market failures or fund projects to reduce pollution. 3. While a pollution tax incentivizes pollution reduction, there are also disadvantages such as the potential for tax evasion or the tax burden falling disproportionately on lower-income groups. Alternative policies need consideration as well.

2. Reducing Externalities – The Use of Pollution Taxes
British Columbia uses a
Carbon Tax
China has raised smoking
taxes
Emissions Trading Scheme
in the EU
Proposed congestion
charge for New Delhi

3. Negative Externalities and a Pollution Tax
Output
MPC1
P1
Q1
Marginal
Private
Benefit
A pollution tax aims to internalize some of the external costs
Costs,
Benefits
£s
MSC
Q2
P2

4. Negative Externalities and a Pollution Tax
Output
MPC1
P1
Q1
Marginal
Private
Benefit
A pollution tax aims to internalize some of the external costs
Costs,
Benefits
£s
MSC
Q2
P2
A pollution tax
on the supplier
increases their
marginal private
cost to MPC2
MPC2

5. Negative Externalities and a Pollution Tax
Output
MPC1
P1
Q1
Marginal
Private
Benefit
A pollution tax aims to internalize some of the external costs
Costs,
Benefits
£s
MSC
Q2
P2
A pollution tax
on the supplier
increases their
marginal private
cost to MPC2
The tax
generates
revenue which
might be ear-
marked for
special projects
MPC2

6. Negative Externalities and a Pollution Tax
Output
MPC1
P1
Q1
Marginal
Private
Benefit
A pollution tax aims to internalize some of the external costs
Costs,
Benefits
£s
MSC
Q2
P2
A pollution tax
on the supplier
increases their
marginal private
cost to MPC2
The tax
generates
revenue which
might be ear-
marked for
special projects
MPC2
Revenue
from the
pollution tax

7. Advantages of Pollution Taxes
Pros A pollution tax internalizes the externality and
therefore makes the polluter pay
A tax utilizes the price mechanism to change
incentives and choices e.g. to reduction
pollution
A tax raises extra tax revenue which might
then be used to address other market failures -
cigarette tax revenue can be used to spend on
NHS smoking ads

8. Disadvantage of Pollution Taxes
Cons
Low price elasticity of demand – the tax may not actually
change behaviour, there might be more effective alternative
policies on offer
Risk of tax evasion and tax avoidance as businesses and
consumers look to by-pass the tax
May hit lower income families most and cause some social
unrest – e.g. taxes on cigarettes are widely regarded as
regressive in their impact
Poorly assigned pollution taxes may bring about government
failure - when government intervention leads to a misallocation
of resources such that there is a net welfare loss from
government intervention, relative to the free market

9. Always Consider the Alternatives!
Tradable pollution permits
Banning
Subsidising "good" alternatives
Behavioural nudges
Bridge information failures
Tougher regulations

10. Evaluation: Problems with Environmental Taxes
Pollution taxes can lead to government failure:
1. Assigning the right level of taxation: There are problems in
setting the right tax so that private cost will exactly equate with
the social cost
2. Consumer welfare effects: Producers may pass on a tax to the
consumers if the demand for the good is inelastic and, as
result, the tax may only have a small effect in reducing demand.
Taxes on some de-merit goods (for example cigarettes) may
have a regressive effect on lower-income consumers and lead
to a widening of inequalities in the distribution of income.
3. Employment and investment consequences: If pollution taxes
are raised in one country, producers may shift to countries with
lower taxes. This will not reduce global pollution, and create
problems such as structural unemployment and a loss of
international competitiveness / worsening of the trade balance.