What is the rationale for taxes addressing negative externalities?

• A. Taxes align private cost with social cost by incorporating external costs into price.
• B. Taxes increase private benefits.
• C. Taxes reduce total welfare.
• D. Taxes have no effect.

Answer: (A)

Taxes on negative externalities aim to align private costs with social costs by requiring producers to pay for the harms their production imposes on others. When a factory pollutes, the private cost to the firm ignores the damage done to neighbors, health, and the environment. By adding a tax equal to the external cost, the producer’s private cost rises to match the social cost. This makes the price paid by consumers—and the quantity produced—adjust toward the socially optimal level, reducing the overproduction that causes the harm. The tax revenue can also be used to mitigate or compensate those affected, reinforcing the incentive to minimize pollution. In short, the tax internalizes the externality, correcting the market failure and improving overall welfare.