Pigouvian Taxation with Costly Administration and Multiple Externalities

Abstract

This paper generalizes corrective taxation to settings with costly administration and many externalities. If administrative cost varies only with the pollution generating activity, the optimal tax is equal to the externality added to the marginal administrative cost, and the private market fully internalizes the externality and administrative cost. If, due to the nature of enforcement, administrative cost varies with tax rates, then optimal policy leaves some portion of externalities uncorrected. As a result, using taxes to modify complement and substitute activities will be welfare increasing. Optimal policy may include subsidizing some harmful activities in order to reduce levels of even more harmful substitutes. Similarly, if the optimal activity mix changes with the scale of production and if higher scales of production use less harmful activity mixes, subsidizing the output of a harmful production process may be optimal.