From Pigou to Extended Liability: On the Optimal Taxation of Externalities under Imperfect Financial Markets

Pigovian taxation of externalities has limited appeal if the tortfeaser has insufficient resources to pay the damage when it occurs. To defend Pigovian taxation in the presence of judgment-proof agents, its proponents point at the many institutions extending liability to third parties. Yet little is known about the validity of Pigou’s analysis in this context. The paper analyzes the costs and benefits of extended liability and investigates whether full internalization is called for in the presence of agency costs between potential tortfeasers and providers of guarantees. Its contribution is two-fold. It first shows that the better the firms’ corporate governance and the stronger their balance sheet, the more closely taxes should track the corresponding externality. It then develops the first analysis of extended liability when guarantors themselves may be judgment-proof and the extension of liability may give rise to further externalities. Relatedly, it derives the curvature of the optimal taxation of externalities in a multi-plant firm.