OPTIMAL CONTROL OF EXTERNALITIES IN THE PRESENCE OF INCOME TAXATION

Authors

  • By Louis Kaplow

    1. Harvard University and National Bureau of Economic Research, U.S.A.
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    • I am grateful to Steven Shavell, the referees, and workshop participants at Harvard University, the Institute for Fiscal Studies, and the NBER for comments and to the John M. Olin Center for Law, Economics, and Business at Harvard University for financial support. Please address correspondence to: Louis Kaplow, Harvard University, Hauser Hall 322 - 1575 Mass. Ave., Cambridge, MA 02138. Phone: 617-495-4101. Fax: 617-496-4880. E-mail: meskridge@law.harvard.edu.


  • Manuscript received October 2009; revised June and September 2010.

Abstract

A substantial literature examines how the Pigouvian directive that marginal taxes should equal marginal external harms needs to be modified in light of the preexisting distortion due to labor income taxation. Additional literature considers distributive concerns. It is demonstrated, however, that simple first-best rules—unmodified for labor supply distortion or distribution—are correct in the model examined. Specifically, setting all commodity taxes equal to marginal harms (and subsidies equal to marginal benefits) can generate a Pareto improvement, as can a marginal reform toward the first-best. Qualifications and explanations for differences from previous work are also presented.

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