Tax reform for dirty intermediate goods: theory and an application to the taxation of freight transport

The purpose of this paper is to study, within a general equilibrium framework, the welfare implications of a balanced-budget tax reform for an externality-generating intermediate input in a second-best economic environment. For purposes of concreteness, the focus is on tax reform for freight road transport to cope with congestion externalities; results for other types of externalities can be derived as special cases. The model takes into account that passenger and freight flows jointly produce congestion, it captures feedback effects in demand, and it allows for existing distortions on all other input and output markets, including the passenger transport market and the labour market. Moreover, it clearly shows that the welfare effects of the reform depend on the instruments used to recycle the tax revenues. A numerical version of the model is calibrated to UK data. The numerical results suggest, among others, that (i) the welfare gain of a given freight tax reform rises with the level of the tax on the market for passenger transport; (ii) the higher the rate of passenger transport taxation, the lower the optimal freight tax; and (iii) compared to lump-sum recycling, both the welfare effects of a tax reform and the optimal tax are substantially higher when revenues are recycled via labour taxes.