Optimal Environmental Taxation from Society's Perspective

Abstract

Much has been made recently of comparisons between the optimal environmental tax and the marginal social damage from pollution when moving from a first-best setting to a second-best setting involving distortionary taxes (Bovenberg and de Mooij, Parry, Bovenberg and Goulder). Generally speaking, the recent literature observes that results for a first-best setting may not be valid in a secondbest setting. The present analysis finds that this same general theme applies when defining social values and, in particular, when expressing the social marginal rate of substitution (MRS) between the environment and income on which the definition of marginal social damage (MSD) is based. We find that a commonly used expression for MSD involving the sum of individuals’ private marginal rates of substitution between the environment and income is only equal to the social MRS at the first-best optimum. In a second-best setting with distortionary taxes, this expression is no longer equal to the social MRS and thus does not provide a consistent measure of relative values from society’s perspective. When MSD is defined based on general analytical expressions for the social MRS (ones that are valid in both first-best and secondbest settings), the optimal environmental tax is found generally to rise above MSD as we move from a first-best to a second-best setting. These results are fully consistent with the intuition of “revenue recycling” and the “double-dividend