Income Taxation, Environmental Emissions and Technical Progress

This paper examines the implications of environmental externalities for income tax design in a growing economy. We describe a model with endogenously generated knowledge, in which technical progress reduces the emissions generated by production activities. In this setting, the lack of internalization of environmental externalities results in an above-optimal long-run rate of growth and leads to an inefficient input mix. If emission taxes are infeasible, differential income tax sheltering of physical and knowledge investment can be effective as a second best remedy. Simulation results from a calibrated model, under a uniform specification of intertemporal and intratemporal substitution possibilities, indicate that the intertemporal allocative effects associated with environmental externalities could dominate intratemporal distortions ; hence, income tax reform could outperform indirect tax reform as a second-best Pigouvian instrument, and perform well in comparison with a first-best instrument, even in economies where environmental emissions are sectorally concentrated.