Health effects and optimal environmental taxes

Abstract

The literature on environmental taxation in the presence of pre-existing distortionary taxes has shown that interactions with these distortions tend to raise the cost of an environmental tax, and thus that the optimal environmental tax is less than marginal environmental damages. A recent paper by Schwartz and Repetto (2000) challenges this finding, arguing that the health benefits from reduced pollution will also interact with pre-existing taxes, and may cause the optimal environmental tax to exceed marginal damages. Schwartz and Repetto’s analysis represented health effects implicitly in the utility function. In contrast, the present paper explicitly represents health effects in an analytically tractable general equilibrium model. This model shows that interactions with health effects from pollution actually will tend to reduce the optimal environmental tax, contradicting, Schwartz and Repetto’s conclusion. This demonstrates the usefulness of explicitly modeling health effects, and it reinforces the general notion that tax-interactions tend to raise the costs of an environmental tax.