Ecotaxation is the use of tax policy to discourage economically inefficient behavior that harms the environment. According to most economists, an unregulated market economy would fail to provide socially ideal or efficient outcomes because of negative externalities. A negative externality is the harm caused to unrelated third parties when two people engage in a market transaction, such as a customer buying a car made in a factory that releases pollution. To deal with negative externalities, most economists endorse a tax on the behavior causing the harm, referred to as a Pigovian tax after economist Arthur Pigou (1877-1959). If correctly calibrated, a Pigovian tax causes the producer to "internalize the externality." A Pigovian tax is thought to promote economic efficiency, because the tax forces individuals to take into account the full consequences of their behavior. After imposing the correct Pigovian tax, the government can allow citizens to make their own decisions without further regulations. Further measures to achieve environmental goals are unnecessary, because market prices, corrected by the Pigovian tax, guide individuals' behavior and lead to a socially desirable outcome.

If industrial processes and land-use changes are causing climate change that imposes harm on people in the present or future, then these activities suffer from large negative externalities. For example, when motorists drive vehicles with poor gas mileage or when an electric utility builds a coal-fired power plant, they are not adequately accounting for the extra climate change damages that others will suffer because of their behavior. But if the government raised taxes on gasoline or imposed a tax on utilities based on the amount of carbon dioxide (CO2) released into the atmosphere, then motorists and utilities would alter their behavior in ways that ultimately reduced anthropogenic climate change. People would still act in their own interest, but the new incentives would ensure that their selfish interests did not jeopardize the welfare of others or of future generations.

Because taxation discourages an activity, most economists favor a policy of "taxing bads, not goods." For example, if the government raised taxes on activities that emit CO2, and used the new revenues to reduce personal income taxes, then citizens would have the incentive to produce more output but in an environmentally friendlier way. Most economists believe that a correctly calibrated Pigovian tax on environmentally harmful activities, accompanied by dollar-for-dollar tax cuts on economically productive activities, would promote economic efficiency. Many proponents of ecotaxation recommend such offsetting tax cuts on other activities in order to overcome political opposition to tax hikes.

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