On the Optimal Taxation of Consumption Externalities

Abstract

The conventional theory of the optimal taxation of consumption externalities (see, for instance, Samuelson, 1969) is applicable to a world where lump-sum transfers are available. When externalities affect individual utilities through aggregate consumption only (the aggregation assumption), according to this theory, a social optimum can be attained by a system of lump-sum transfers and uniform taxes-subsidies on the externality-causing goods.1 A tax-subsidy is imposed on each such good; the amount equals the sum across individuals of the marginal rates of substitution (2MRS) between the aggregate consumption of this good and the numeraire good. Diamond (1973), Starrett (1972), and others relaxed the aggregation assumption, while still maintaining the framework of lump-sum transfers. In this paper we derive explicit tax formulae in a more realistic setting, where lump-sum transfers are not available. However, the aggregation assumption is retained. The formal analysis developed here applies to both external economies and diseconomies; in order to avoid needless repetition, the interpretation of the results is confined to the latter case. When lump-sum taxes are not available, we encounter some problems that otherwise do not exist. Fortunately, these problems are similar in nature to those associated with the optimal provision of public goods. In particular, one may conjecture from the treatment of public consumption by Diamond and Mirrlees (1971) in what ways the optimal taxes-subsidies will be different in our case from what is suggested by the conventional theory. First, with no lump-sum transfers available, the marginal social welfare of income is not necessarily equalized across individuals; therefore it is not appropriate to add up the individual willingness to pay for a unit decrease in the aggregate consumption of an externality-causing good (the MRS's). Thus, as in Diamond and Mirrlees (1971) the term 2MRS