Corrective Taxation of a Consumption Externality in the Presence of an Optimal Non-linear Income Tax

This paper is concerned with the problem of combining a non-linear income tax with an indirect externality correcting tax. The analysis is performed in a model economy with two types of individuals and two types of consumption goods. The government wants to redistribute from the more able individuals to the less able, and also to correct for the externality arising from the total consumption of the dirty good. It turns out that the optimal tax structure depends on the complementarity or substitutability between the dirty good and leisure. The second-best externality correcting tax can be interpreted as consisting of a redistributive and an environmental component. Consequently, the dirt tax can be lower or higher than the first-best Pigouvian tax.