Ramsey, Pigou, and a Consumption Externality

This paper analyzes the effects of consumption externalities on optimal taxation and on the social cost and optimal levels of public good provision. If public and private goods are Hicksian complements and no lump sum taxes are available, the second-best level of public good provision can exceed the first-best level. In contrast to economies without externalities, this result even holds for Cobb-Douglas economies with homogeneous agents. Heterogeneity of agents raises the second-best commodity tax rate due to equity considerations, but lowers the tax rate due to the concern for externality-correction.