Empirical Estimates for Environmental Policy Making in a Second- Best Setting

This study estimates parameters necessary to calculate the optimal second-best gasoline tax, most notably the cross-price elasticity between gasoline and leisure. Prior work indicates that in a second-best setting with distortionary income taxes, both the cost of environmental regulation and the optimal environmental tax rate depend crucially on the cross-price elasticity between a polluting good and leisure. However, no prior study on second-best environmental regulation has estimated this elasticity. Using household data, we find that gasoline is a relative complement to leisure, and thus that the optimal gasoline tax is significantly higher than marginal damages–the opposite of the result suggested by the prior literature. Following this approach to estimate cross-price elasticities with leisure for other major polluting goods could strongly influence estimates of optimal environmental taxes.