Optimal Control of Externalities in the Presenceof Income Taxation

A substantial literature examines second-best environmental policy, focusingparticularly on how the Pigouvian directive that marginal taxes should equalmarginal external harms needs to be modified in light of the preexistingdistortion due to labor income taxation. Additional literature is motivated bythe possibility that distributive concerns should amend the internalizationprescription. It is demonstrated, however, that simple first-best rules –unmodified for labor supply distortion or distribution – are correct in anatural, basic formulation of the problem. Specifically, setting all commoditytaxes equal to marginal harms (and subsidies equal to marginal benefits) cangenerate a Pareto improvement. Likewise, a marginal reform in the directionof the first-best can yield a Pareto improvement. Qualifications andexplanations for differences from previous work are also presented.[...]