Empirical Estimates for Environmental Policy Making in a Second-Best Setting

Abstract

This study estimates parameters necessary to calculate the optimal second-best gasoline tax, most notably the cross-price elasticity between gasoline and leisure. Prior work indicates that in a second-best setting with distortionary income taxes, both the cost of environmental regulation and the optimal environmental tax rate depend crucially on the cross-price elasticity between a polluting good and leisure. However, no prior study on second-best environmental regulation has estimated this elasticity. Using household data, we find that gasoline is a relative complement to leisure, and thus that the optimal gasoline tax is significantly higher than marginal damages - the opposite of the result suggested by the prior literature. Following this approach to estimate cross-price elasticities with leisure for other major polluting goods could strongly influence estimates of optimal environmental taxes.

Keywords: Second-best environmental taxes, optimal taxes, demand system

JEL Classification: H21, H23, Q5