Setting Environmental Taxes in a Second-best World

This paper compares the optimal environmental tax to marginal social damages (MSD) in a second-best setting with preexisting taxes using both analytical and numerical models. The optimal environmental tax is found generally to exceed MSD and to rise with increased revenue requirements – a relationship which holds for both productivity externalities and amenity externalities. The simple logic for the result stems from the complementary, dual roles of the environmental tax in controlling pollution and raising revenue. An alternative measure of marginal damages used in the recent literature, and based on summing households’ willingness to pay, is found to equal MSD only at the first-best optimum, and otherwise to be either higher or lower than MSD depending on taxes and the type of externality.