Direct versus indirect pigovian taxation

Abstract

This paper considers the theory of optimal taxation in the presence of externalities when it is the uses of commodities in particular consumption processes which generate externalities, rather than the consumption of certain commodities as such. If the government is constrained to using ordinary commodity taxes (for reasons of imperfect information, costly control, etc.), it is demonstrated that there is a case for having taxes or subsidies on related goods in addition to a tax on the externality-creating commodity itself. The analysis also identifies the conditions under which related goods should be subsidized or taxed.