Optimal Control of Externalities in the Presence of Income Taxation

27 Pages Posted: 14 Jul 2006 Last revised: 20 Sep 2010

See all articles by Louis Kaplow

Louis Kaplow

Harvard Law School; National Bureau of Economic Research (NBER)

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Date Written: June 2006

Abstract

A substantial literature examines second-best environmental policy, focusing particularly on how the Pigouvian directive that marginal taxes should equal marginal external harms needs to be modified in light of the preexisting distortion due to labor income taxation. Additional literature is motivated by the possibility that distributive concerns should amend the internalization prescription. It is demonstrated, however, that simple first-best rules %u2013 unmodified for labor supply distortion or distribution %u2013 are correct in a natural, basic formulation of the problem. Specifically, setting all commodity taxes equal to marginal harms (and subsidies equal to marginal benefits) can generate a Pareto improvement. Likewise, a marginal reform in the direction of the first-best can yield a Pareto improvement. For other reforms, a simple efficiency test characterizing when a Pareto improvement is possible is offered. Qualifications and explanations for the substantial departure from results in previous work are also elaborated.

Suggested Citation

Kaplow, Louis, Optimal Control of Externalities in the Presence of Income Taxation (June 2006). NBER Working Paper No. w12339. Available at SSRN: https://ssrn.com/abstract=912449

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