Pigou meets Mirrlees: On the irrelevance of tax distortions for the second-best Pigouvian tax |
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| Affiliation: | 1. Department of Economics, Erasmus School of Economics, Erasmus University Rotterdam, PO box 1738, 3000 DR Rotterdam, The Netherlands;2. Tinbergen Institute, The Netherlands;3. CESifo, Germany;4. International Monetary Fund, United States;5. Oxford University Centre for Business Taxation, United Kingdom;1. Department of Economics, Georgia State University, PO Box 3992, Atlanta, GA 30302-3992, USA;2. NBER, USA;1. ESRC Centre for Climate Change Economics and Policy, Grantham Research Institute on Climate Change and the Environment, London School of Economics and Political Science, UK;2. Department of Geography and Environment, London School of Economics and Political Science, UK;3. Oxford Martin School and Smith School of Enterprise and the Environment, University of Oxford, Oxford UK;4. Department of Micro-economics, Waroqué School of Economics and Management, University of Mons, Belgium;1. Department of Economics, CentER, TSC, Tilburg University, P.O. Box 90153, 5000 LE Tilburg, The Netherlands;2. Department of Economics, Aalto University, P.O. Box 21240, 00076 Aalto Helsinki, Finland;1. Department of Economics, University of Illinois at Urbana–Champaign, USA;2. Department of Law, University of Milan, Italy;3. UCFS Uppsala, Sweden;4. CESifo, Germany;1. American Enterprise Institute, 1150 17th St. NW, Washington, DC 20036, USA;2. The Brookings Institution, USA |
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| Abstract: | This paper extends the Mirrlees (1971) model of optimal income redistribution with optimal corrective taxes to internalize consumption externalities. Using general utility structures and exploring both linear and non-linear taxes, it is demonstrated that the optimal second-best tax on an externality-generating good should not be corrected for the marginal cost of public funds, since it equals one in the optimal tax system. In the optimum, distortions of income taxes are equal to marginal redistributional gains. If the government does not have access to a non-distortionary marginal source of finance, the marginal cost of public funds can be either larger or smaller than one depending on subjective preferences for income redistribution. The optimal second-best corrective tax is then either higher or lower than the Pigouvian level. The findings in this paper generalize and amend prior results based on representative-agent models, shedding new light on the weak double-dividend hypothesis, and on the welfare gains of recycling revenue from environmental taxes. |
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| Keywords: | Marginal cost of public funds Optimal environmental taxation Optimal redistribution Externalities |
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