Pigovian Tax - Lump-sum Tax Subsidy

Lump-sum Tax Subsidy

In 1980, a new critique of Pigouvian taxes emerged from Dennis Carlton and Glenn Loury. They argued that Pigouvian taxes alone would not create an efficient outcome in the long-run, because the taxes controlled only the scale of the individual firms, not the number of firms in the particular industry. In the case of pollution, if the firms each produced a fraction of what they produced before, but the number of firms increased exponentially, the amount of pollution would still increase. To prevent this, Carlton and Loury recommend a policy with the potential to regulate the number of firms in an industry: lump-sum taxes or lump-sum subsidies.

Carlton and Loury present four basic arguments in their article. First, Pigouvian taxes work in the short-term, because the number of firms cannot vary. Second, Pigouvian taxes do not work in the long-term because the number of firms can vary. Third, an industry with a specific number of firms and scale can achieve the long-run social optimum (LRSO). The best option is to add an entry tax for potential firms and a subsidy for current firms to restrict a movement in the number of firms. Fourth, it is possible for a tax policy to create a LRSO.

Robert Kohn responded to this article in “The Limitations of Pigouvian Taxes as a Long-Rum Remedy for Externalities: Comment,” saying that a Pigouvian tax on pollution emissions can, in fact, create the long-run social optimum without a lump-sum tax-subsidy. Carlton and Loury responded the same month, clarifying that they were discussing a Pigouvian tax on output; whereas, Kohn was discussing a Pigouvian tax on emissions. Carlton and Loury provide numerical proofs as to why these are different. Ultimately, they argue that there are some cases in which a single tax on emissions will produce the LRSO and others in which a single tax on output will attain the LRSO. Either case only works with the taxes properly determined.