Second-best taxation of emissions and polluting goods

Abstract

This paper studies the problem of the design of an integrated system of second-best emission and output taxes in a model where production costs are negatively correlated with their emissions. It shows that (i) the first-best Pigouvian rule (of equating the marginal private benefit of emissions in production to the marginal social damage of emissions) must be modified in the second best; (ii) implementation of the modified Pigouvian rule requires all firms to face the same marginal emission tax equal to the marginal social damage of emissions plus an adjustment term reflecting optimal tax objectives; (iii) it may not be necessary to directly tax the polluting goods; the latter taxes can be subsumed in the emission tax function; (iv) output taxes must be set solely on the basis of optimal tax objectives; no Pigouvian adjustment is required; (v) if emission taxes are restricted to be proportional, and commodity taxes are constrained, the modified Pigouvian rule will no longer be optimal; (vi) if preferences are weakly separable in emissions and other goods, the Pigouvian rule remains valid, the marginal emission tax is Pigouvian, and emission and commodity tax instruments can be set separately to address different objectives: a proportional emission tax corrects for externalities, while commodity taxes are determined solely on the basis of optimal tax considerations.