Pigouvian taxes do NOT produce deadweight losses
The trouble that my students encountered — and many teachers of economics fail to clarify — is that fiscal taxes distort prices to generate revenue while Pigouvian taxes correct prices to affect behavior. (We explore the tension between these two goals in this paper on groundwater taxes.)
Bottom Line: We use the same word (“tax”) to refer to two different policy instruments. Fiscal taxes generate revenue with some reduction in efficiency; Pigouvian taxes generate revenue as they improve efficiency. (That’s why they are called win-win, but don’t tell that to the people creating the pollution!)
* Miscalibrated taxes of all types create deadweight losses from being set at the wrong level, but those losses are not present in theory.
** Deadweight losses will be lowest when behavior changes by the smallest amount, i.e., it’s best to tax the most inelastic behavior.
*** For more on why politicians prefer command and control over Pigouvian taxes, read this paper [pdf] by Buchanan and Tullock. Buchanan just died; he and Tullock are responsible for much of Public Choice theory, i.e., the idea that politicians and bureaucrats may serve themselves, not the public interest. Here’s my review of their brilliant book on constitutions and laws.