What Are Corrective Taxes?

Adam Smith, 18th century economic thinker and author of the book "The Wealth of Nations," asserted that people are motivated by their own self-interests. Benevolence is not the primary reason for positive actions, Smith argued. People must have a monetary or other type of incentive that benefits them directly. Corrective taxes apply this line of thinking and tax negative externalities, or negative impacts of business and economic activities on bystanders, in hopes that monetary losses will result in a reduction in such activities.

British economist Arthur Pigou expanded on the concept of externalities in his book "The Economics of Welfare." He not only discussed negative externalities, such as pollution and oil drilling, but also discussed positive externalities, or activities that have a positive impact on bystanders, such as energy efficiency measures, charity work and education. Because of his work, corrective taxes on negative externalities, and subsidies on positive externalities, are now called Pigouvian taxes and Pigouvian subsidies.

Many businesses incur corrective, or Pigouvian, taxes. Mining companies, chemical manufacturing firms or industrial facilities may be subject to corrective taxes if they're associated with pollution. Other industries, such as alcohol and tobacco, may also have to pay corrective taxes, as their products are considered vices. Ideally, if a business has to pay an amount of money in corrective taxes that is equal to the amount of harm they cause bystanders, then they will reduce the harm they do so that they can also reduce this cost. People also pay corrective taxes on negative externalities, such as the gasoline needed to drive an automobile, also considered a source of pollution. As of 2007, corrective taxes on gas were 40 cents per gallon.

Say Fictional Company XYZ dumped 10,000 gallons of waste last year. As a corrective tax, the EPA forces factories to pay $1,000 for each gallon of waste that's dumped, for a total of $10,000,000 for Company XYZ. The following year, Company XYZ took measures to reduce the amount of waste it dumped to lessen the amount of corrective tax it had to pay. Another example is the gasoline tax. Given that driving is associated with pollution, traffic congestion and auto accidents, corrective taxes on gasoline might help promote carpooling and other alternative forms of transportation and reduce those associated negative externalities.

The primary benefit of a corrective tax is the provision of an incentive for companies to reduce activities such as pollution by creating cleaner, greener technology. Corrective taxes can be more efficient at reducing pollution than regulation. The book "Principles of Economics" by N. Gregory Mankiw explains and exemplifies this. Say, for instance, EPA regulation says factories cannot dump more than 300 gallons of waste into the water. Factories will lower their dumping down to the 300 gallons, but have no incentive to dump less than that 300 gallons. With a corrective tax, factories have an incentive to continue to reduce their dumping to the lowest level possible to lower their costs as much as possible.

Because corrective taxes are based on an estimated value of the amount of damage negative externalities cause, as opposed to the actual amount of damage it causes, the numbers are not always as accurate as they should be. Harvard University discusses factors that impact the amount of damage an externality such as pollution causes, including how many people and wildlife live in the area where a factory is polluting and the type of chemical being emitted.