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 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 sustainability between the dirty good and leisure.