How to Internalize Pollution Externalities Through 'Excess Burdening' Taxes

Taxes are usually called distortionary if they are not lump-sum (Ballard and Fullerton 1992). It is well known that if distortionary taxes are introduced in a formerly Pareto efficient perfectly competitive economy they induce an excess burden on the economy. But suppose, the economy is subject to pollution that renders the competitive allocation inefficient in the absence of any taxes. Then it is equally well-known since Pigou that there are taxes on the pollution-generating activity, i.e. emission taxes, allowing to eliminate the allocative inefficiency, provided that an appropriate tax rate is chosen and that the tax revenues are recycled in a non-distortionary way. Such taxes are usually called corrective taxes. Obviously, corrective taxes are necessarily distortionary, because it is the tax base eroding effect of increasing the rate of a corrective tax that eventually 'internalizes' the externality.