Impact of taxes and subsidies
                     Impact of taxes 
and subsidies
Introduction
The use of taxes and subsidies to 
tackle the problem of externalities is 
a market-based method of control as 
it works through the price system, 
i.e. through the impact of changes in 
prices
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When to grant 
a subsidy
If negative externalities exist, and there 
is allocative inefficiency at the free 
market price because SMC is greater 
than price and overproduction is 
occurring, then the appropriate solution 
would be to tax the good; if, on the 
other hand, the market is under-
producing because positive 
externalities are not being taken into 
account, it would be appropriate for the 
government to grant a subsidy. 
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Taxes
There are two types of tax which may 
be applied to address the problem of 
negative externalities: a tax set equal 
to each firm's marginal external costs 
and an environmental or 'green' tax.
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The policy of 
taxing
The policy of taxing firms according to 
the marginal external costs that they 
impose on society can be illustrated 
using figure 1 below. In this example 
we assumed that a firm was dumping 
waste products into a river. 
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The policy of 
taxing cont.
The government would have to assess 
the cost to society of such an action, 
and impose a tax on the offending firm 
equal to the value of the marginal 
external cost (or negative externality); 
in this case the tax would internalise 
the externality by making the polluter 
pay. 
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An 
environmental 
tax
An environmental tax could be imposed 
either on a product responsible for 
creating pollution, or on the inputs to 
an industry which have caused 
environmental damage e.g. carbon 
producing fuels, which are believed to 
play the major role in the process of 
global warming. 
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Subsidies
Whilst a tax may be imposed on 
generators of negative externalities, a 
subsidy may be granted to generators of 
positive externalities to ensure a higher 
level of consumption and production than 
would arise through the completely free 
interaction of market forces. 
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Issues arising from 
the tax/subsidy 
approach
Advocates of this approach would argue 
that it permits the forces of demand and 
supply to operate. At the same time 
generators of negative externalities are 
induced to 'clean-up their act' because the 
less pollution they create, the less their 
tax liability; and conversely, grants and 
subsidies encourage greater output and 
consumption of those goods involving net 
social benefits.
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Difficulties
• For the tax/subsidy solution to work the 
exact value of the marginal external 
cost and the marginal external benefit 
must be established so that taxes and 
subsidies, respectively, of exactly the 
right size can be applied; in reality it is 
not only extremely difficult to identify 
external costs and benefits, but it also 
an extremely arbitrary matter trying to 
ascribe a monetary value to them
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Difficulties cont.
• From an environmental point of view a 
tax on pollution does not solve the 
problem, as pollution is still allowed to 
continue; the tax merely provides a 
market-led inducement to firms to find 
cleaner ways of producing so as to 
reduce their costs; moreover, the 
unwilling third parties who receive 
pollution as a negative externality are 
not in any way compensated.
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