Optimal control of externalities in the presence of income taxation

Abstract

A substantial literature examines 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 considers distributive concerns. It is demonstrated, however, that simple first-best rules-unmodified for labor supply distortion or distribution-are correct in the model examined. Specifically, setting all commodity taxes equal to marginal harms (and subsidies equal to marginal benefits) can generate a Pareto improvement, as can a marginal reform toward the first-best. Qualifications and explanations for differences from previous work are also presented. © (2012) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.