Imposing a tax on an activity that generates an external benefit will cause participants in the activity to increase the amount of the activity undertaken.

Question

Quizplus · Accepted Answer

Imposing a tax on an activity that generates an external benefit will cause participants in the activity to decrease the amount of the activity undertaken, as the tax makes the activity more expensive. This is because external benefits are positive effects that spill over onto third parties, so the activity is not fully incentivized by private gains alone. A tax on such an activity corrects for this market failure by making private costs more reflective of the overall social costs, but it also reduces the incentive for individuals to engage in that activity, resulting in a reduction of overall welfare.

Imposing a Tax on an Activity That Generates an External