Externality Taxes and Subsidies

Abstract

Most economists consider taxes on externalities a feasible means of control when outright prohibition would result in excessive reduction of desirable activities (such as electricity production which jointly supplies various pollutants). However, the literature lacks a rigorous and general externality tax model. This chapter presents a tax–subsidy algorithm that is valid under very general conditions —convex production functions allowing for many products and firms and permitting externalities to be varied independently of salable commodity levels. The prevailing pessimistic conclusions concerning tax–subsidy schemes are wrong. The chapter presents a justification of several specific suggestions for the (approximate) taxes and subsidies on some pollutants toward which the political process is moving. When many are affected by the same pollutant, the tax share going to each injured party (generally different for each) may be paid to the government and not redistributed. This convenience in a world of positive administrative costs makes particular sense when the parties ultimately responsible for the pollution such as consumers of electricity form the majority of those injured by it. The optimal tax will typically be less for one polluter farther from pollution centers than another producer of identical pollutants.