VAT Theories - Taxing Externalities - Why tax?

The consumption of many goods will have effects on people other than those consuming them. These costs are known as external costs or negative externalities. The cost to society - the social costs - are therefore the private costs and the external costs. These two together are the full cost to society.

The external costs of people's actions are often not taken into account by those people when they consume products and so they will regard the good as cheaper than it really is. Take for example smoking. The private cost of smoking to an individual is the financial cost - the amount they pay for their cigarettes. However, there are further costs to society. These may include any medical costs because of smoking-related diseases, time (and therefore production) lost through illness, the possibility that passive smoking may cause illness and so on. Because people do not take these costs into account, they may over-consume the product, because it is seen as cheaper than it really is. This is shown in the diagram below:

The private cost of smoking is represented by the MC curve. If people take account of just these costs then they will consume Q1. However, as discussed above, there are further costs - external costs - and these are shown by the gap between the MC curve and the MSC curve. The MSC (marginal social cost) curve includes all costs. On the basis of all these costs, people should only consume Q2: the presence of external costs will often lead to over-consumption of a good.

To try to cope with this problem and ensure that the optimum quantity of a good is consumed, the government may choose to tax the good. This tax can be arranged to be equivalent to the value of the external costs and will then increase the price by the required amount and, hopefully, ensure that the correct quantity is consumed (Q2 in the diagram above). The main problem for the government is accurately assessing the value of the external costs and therefore setting the value of the tax appropriately.