The Case for Subsidizing Harm: Constrained and Costly Pigouvian Taxation with Multiple Externalities

The Case for Subsidizing Harm: Constrained and Costly Pigouvian Taxation with Multiple Externalities, International Tax and Public Finance, 29(2) (2022), 408-442.

41 Pages Posted: 30 Aug 2016 Last revised: 16 May 2022

See all articles by Daniel Jaqua

Daniel Jaqua

Albion College

Daniel Schaffa

University of Richmond School of Law

Date Written: August 27, 2016

Abstract

Many activities are subsidized despite generating negative externalities. Examples include needle exchanges and energy production subsidies. We explain this phenomenon by developing a model in which the policymaker faces constraints or costs. We highlight three examples. First, it may be optimal to subsidize a harmful activity if the policymaker cannot set the first-best tax on an externally harmful substitute. Second, it may be optimal to subsidize a harmful production process if the activity mix at lower levels of output uses more harmful activities than the activity mix at higher levels of output. Third, it may be optimal to subsidize a harmful activity if there is a large administrative cost associated with taxing a harmful substitute. We also show how the functional form of the cost of administering a Pigouvian tax affects the optimal tax. When administrative cost is a function of only tax rates, the policymaker should tax each activity. However, an increase in the tax presents a tradeoff: lower externality, but higher administrative cost. A subsidy may be optimal for some externally harmful activities. When administrative cost is a function of only activity levels, it may not be optimal to tax every activity. If it is optimal to tax all of the activities, the policymaker should set the tax equal to the externality plus the marginal administrative cost. If it is not optimal to tax every activity, the complementarity between activities comes into play and it may be optimal to subsidize externally harmful activities.

Keywords: Administrative cost, Corrective taxation, Externality, Optimal taxation, Optimal tax systems, Pigouvian taxation, Second best

JEL Classification: H23, H21

Suggested Citation

Jaqua, Daniel and Schaffa, Daniel, The Case for Subsidizing Harm: Constrained and Costly Pigouvian Taxation with Multiple Externalities (August 27, 2016). The Case for Subsidizing Harm: Constrained and Costly Pigouvian Taxation with Multiple Externalities, International Tax and Public Finance, 29(2) (2022), 408-442., Available at SSRN: https://ssrn.com/abstract=2831563 or http://dx.doi.org/10.2139/ssrn.2831563

Daniel Jaqua

Albion College ( email )

Albion, MI 49224
United States

Daniel Schaffa (Contact Author)

University of Richmond School of Law ( email )

28 Westhampton Way
Richmond, VA 23173
United States

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