Setting Environmental Taxes in a Second-best World

This paper compares the optimal environmental tax with two alternative definitions of marginal environmental damages. One definition reflects the social marginal rate of substitution between income and the environment; the other reflects the sum of households' marginal willingness to pay. The analysis finds that the definition based on the social marginal rate of substitution provides a consistent benchmark for setting environmental taxes that is compatible with both the Pigouvian principle and the double dividend hypothesis. The definition based on the sum of households' marginal willingness to pay, however, is found to be incompatible with optimal taxation and an unreliable benchmark for making welfare inferences.