Optimal Control of Externalities in the Presence of Income Taxation
27 Pages Posted: 31 Jul 2006
There are 2 versions of this paper
Optimal Control of Externalities in the Presence of Income Taxation
Optimal Control of Externalities in the Presence of Income Taxation
Date Written: June 2006
Abstract
A substantial literature examines second-best environmental policy, focusing particularly on how the Pigouvian directive that marginal taxes should equal marginal external harms needs to be modified in light of the preexisting distortion due to labor income taxation. Additional literature is motivated by the possibility that distributive concerns should amend the internalization prescription. It is demonstrated, however, that simple first-best rules - unmodified for labor supply distortion or distribution - are correct in a natural, basic formulation of the problem. Specifically, setting all commodity taxes equal to marginal harms (and subsidies equal to marginal benefits) can generate a Pareto improvement. Likewise, a marginal reform in the direction of the first-best can yield a Pareto improvement. For other reforms, a simple efficiency test characterizing when a Pareto improvement is possible is offered. Qualifications and explanations for the substantial departure from results in previous work are also elaborated.
JEL Classification: D61, D62, D63, H21, H23, K32
Suggested Citation: Suggested Citation
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