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Second-Best Optimal Emission Pricing

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  • Ross McKitrick

    (Department of Economics and Finance, University of Guelph, Guelph ON Canada)

Abstract

The classical Pigovian analysis leads to the “polluter pay†concept, in which firms pay the marginal damages (MD) of their emissions, evaluated where MD equals marginal abatement costs (MACs). But Sandmo (1975) showed that the emission tax rate should be normalized by the marginal social cost of the tax system or it will lead to a suboptimal outcome. This insight implies a distinction between private and social MACs, the implication of which is largely ignored in environmental policy textbooks and in practice. Here I review the underlying theory, provide a simple graphical summary and then offer a formal derivation in general equilibrium. The Pigovian and Sandmo pricing rules can be reconciled by noting that tax distortions drive a wedge between private and social MACs and the Sandmo rule compensates for the difference. I discuss some of the practical implications and surprising paradoxes created by the Sandmo analysis. I then present a detailed discussion of how the Sandmo model can be applied to the development of optimal climate policy.

Suggested Citation

  • Ross McKitrick, 2024. "Second-Best Optimal Emission Pricing," Working Papers 2403, University of Guelph, Department of Economics and Finance.
    • Handle: RePEc:gue:guelph:2024-03
    as

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    File URL: http://www.uoguelph.ca/economics/repec/workingpapers/2024/2024-03.pdf
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    References listed on IDEAS

    as
    1. William Nordhaus, 2018. "Projections and Uncertainties about Climate Change in an Era of Minimal Climate Policies," American Economic Journal: Economic Policy, American Economic Association, vol. 10(3), pages 333-360, August.
    2. Boardman, Anthony E. & Greenberg, David H. & Vining, Aidan R. & Weimer, David L., 2020. "Efficiency without Apology: Consideration of the Marginal Excess Tax Burden and Distributional Impacts in Benefit–Cost Analysis," Journal of Benefit-Cost Analysis, Cambridge University Press, vol. 11(3), pages 457-478, October.
    3. Newell, Richard G. & Prest, Brian C. & Sexton, Steven E., 2021. "The GDP-Temperature relationship: Implications for climate change damages," Journal of Environmental Economics and Management, Elsevier, vol. 108(C).
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    Keywords

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    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy

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