Pigovian tax

A Pigovian tax (also spelled Pigouvian tax) is a tax levied on a market activity that generates negative externalities. The tax is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. A Pigovian tax equal to the negative externality is thought to correct the market outcome back to efficiency.

In the presence of positive externalities, i.e., public benefits from a market activity, the market tends to under-supply the product. Similar logic suggests the creation of Pigovian subsidies to increase the market activity.

Pigovian taxes are named after economist Arthur Pigou who also developed the concept of economic externalities. William Baumol was instrumental in framing Pigou's work in modern economics.