Pigouvian taxes are only used to correct external effects of market activity. The concept of pigou-tax includes environmental taxes for which there are no external effects, but for other undesirable reasons (moral or ideological).
A pigovian tax is regarded as a conventional way of instituting a modicum of market forces, which translates to improved market efficiency in situations where externality effects are present. Pollution rights markets are typically not as effective as Pigovian taxes but are sometimes more favorable to policy makers because they do no cost polluters.
The fiscal effect of a pigouvian tax can not be calculated according to the level of activities, as reduced by applying the tax to the harmful activity, thus contracting tax revenue. Fiscal effect is the magnitude of the activity, which is exercised in applying the tax. In contrast to subsidies, it is burdensome for pigou taxes to be steered by purpose standards.
Markets for emissions trading were established to institute improved allocative efficiency and information channels in respect of the pollution externality issue. Pollution rights markets constitute a component of the discipline of environmental economics and free-market environmentalism.
Since the pigou-tax purposes are non-fiscal, the tax burden for businesses has to be kept as low as possible. This can be done for example by a variation of the base, and the only condition involves the tax effect at the border.
A classic example involves a factory which emits pollutants into a river, and affects the livelihood of those dependent on it (e.g, fishermen). Without regulation, it is the factory’s prerogative to decide volumes of production, but does not consider the impact of their activities on the externalities. Such a scenario is defined as macro-inefficient, therefore, something has to be done about factory’s pollution.
There are several ways to control the factory’s production, and these include predetermined maximum levels of production enforced by the state, although such action can not be applied to an entire economy. Thus the state could set individual limits. The trading of emission allowances would limit the production of the factory as well. And essentially the state can levy a pigou tax.
Through subsequent negotiations between the polluter (factory) and the authorities, a different emission rate can be agreed upon. The pigouvian tax may violate the the factory’s overall efficiency, and also result in market outlets. In the case of an imperfect market, even a welfare deterioration is possible.
Another classic example of the role of such taxes on the environment (externalities) is clearly shown by the Shell oil spill in the Gulf of Mexico, in which President Obama took full responsibility of how the matter is handled. This demonstrates the interests and obligations of the state in the welfare of externalities (environment).