Externalities and Corrective Taxes

Abstract

Consider a factory which produces some unspecified product called X. The process of producing X involves the creation of an external diseconomy for a nearby business. It is generally recognized that this diseconomy may be the result of some resource used in the production of X such as smoke created from a burning process. However, the participants in the recent discussion of externalities, as well as Pigou, have assumed either by means of their examples, or explicitly, that in such cases the corrective tax should be placed on the production of X. This procedure, except under rather restrictive conditions, is fundamentally incorrect. If a corrective tax exists, it must be placed either on the smoke output or, under certain conditions, on the resource input from which the smoke is generated.