Environmental and Distortionary Taxes: Comment
This note argues that the conclusions and inferences in a recent literature on second-best environmental taxation are due to the use of a particular definition of "marginal social damage," one that is not based on the marginal rate of substitution between income and the environment for the social planner's problem. In particular, the definition used values an incremental unit of income in a way that does not reflect its Pareto efficient use. When the definition of marginal social damage from pollution is based on the social marginal rate of substitution between income and environmental quality, the optimal environmental tax is found to exceed marginal social damage in a second-best setting with revenue-raising taxes. Since, in the first-best case with no binding revenue requirement, the optimal environmental tax equals marginal social damage, it follows directly that the optimal environmental tax rises with increasing and binding revenue requirements over the range under consideration.
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