Page 1Page 2Page 3Page 4Page 5Page 6Page 7Page 8Page 9Page 10Page 11Page 12Page 13Page 14Page 15Page 16Page 17Page 18Page 19Page 20Page 21Page 22Page 23Page 24Page 25Page 26ISSN 1045-6333 HARVARD JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS OPTIMAL CONTROL OF EXTERNALITIES IN THE PRESENCE OF INCOME TAXATION Louis Kaplow Discussion Paper No. 547 06/2006 Harvard Law School Cambridge, MA 02138 This paper can be downloaded without charge from: The Harvard John M. Olin Discussion Paper Series: http://www.law.harvard.edu/programs/olin_center/ The Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/abstract_id=######Harvard University and National Bureau of Economic Research. I am grateful to Steven*Shavell, Roberton Williams, and workshop participants at Harvard University and the NBER forcomments and to the John M. Olin Center for Law, Economics, and Business at HarvardUniversity for financial support.JEL Classes D61, D62, D63, H21, H23, K32Optimal Control of Externalitiesin the Presence of Income TaxationLouis Kaplow*AbstractA substantial literature examines second-best environmental policy, focusing particularlyon how the Pigouvian directive that marginal taxes should equal marginal external harms needsto be modified in light of the preexisting distortion due to labor income taxation. Additionalliterature is motivated by the possibility that distributive concerns should amend theinternalization prescription. It is demonstrated, however, that simple first-best rules –unmodified for labor supply distortion or distribution – are correct in a natural, basicformulation of the problem. Specifically, setting all commodity taxes equal to marginal harms(and subsidies equal to marginal benefits) can generate a Pareto improvement. Likewise, amarginal reform in the direction of the first-best can yield a Pareto improvement. For otherreforms, a simple efficiency test characterizing when a Pareto improvement is possible is offered. Qualifications and explanations for the substantial departure from results in previous work arealso elaborated.First Draft: June 2004; Revised Draft: June 2006- 1 -Optimal Control of Externalitiesin the Presence of Income TaxationLouis Kaplow© 2006 Louis Kaplow. All Rights Reserved.1. IntroductionThe control of externalities is a complex second-best problem. The first-bestprescription, following Pigou (1920), is to set marginal taxes and subsidies equal to marginalexternal harms and benefits. Because of the preexisting distortion due to labor income taxation,however, researchers have explored how the Pigouvian rule needs to be modified on account ofthe interaction between environmental regulation and the income tax, particularly concerning theneed to raise revenue and the indirect effects of environmental policy on labor supply. Workbegan in the 1970’s with Sandmo (1975) and others, following the growing interest in optimaltaxation more generally. Subsequently, researchers became interested in the possibility of adouble dividend – that corrective taxation may both enhance welfare by internalizingexternalities and also raise revenue that would allow a reduction in distortionary income taxation. See, for example, Ballard and Medema (1993), Cordes, Nicholson, and Sammartino (1990), andPearce (1991). This work, in turn, led to an extensive modern literature on environmentalregulation, much of which suggests that there is no double dividend and, instead, that optimalenvironmental control may well fall short of the Pigouvian first best. For a survey and acollection of literature, see respectively Bovenberg and Goulder (2002) and Goulder (2002).An additional second-best problem involves distribution. See, for example, Casler andRafiqui (1993) and West (2004). Because many proposed correctives, such as heightenedtaxation of gasoline, are believed to be regressive and, moreover, environmental benefits mayhave values that rise (perhaps disproportionately) with income, distributive concerns seempotentially important.This article seeks to advance our understanding of the regulation of externalities byexamining the problem in what seems to be a natural and foundational setting in light of work ontaxation more generally: namely, in a model in which there can be taxes or subsidies on eachcommodity and a nonlinear income tax, and in which individuals differ in their earning abilities. Specifically, the question addressed is, in a world in which there may be externalities, whatreforms of commodity taxes and subsidies can generate Pareto improvements, beginning withany arbitrary initial system. By including a preexisting income tax – with no restriction on how itis set initially – interactions involving tax revenue and labor supply will be taken into account. And by focusing on Pareto improvements, concerns about distribution will be addressed.Three principal results are presented in sections 2 through 4 respectively. First, in astandard, simple setting (specifically, in which utility is weakly separable in labor), it is possible- 2 -to move from any set of commodity taxes and subsidies to first-best Pigouvian taxes andsubsidies – wherein each tax or subsidy equals marginal harm or benefit – in a manner thatgenerates a Pareto improvement. Second, subject to some additional assumptions, any marginalchange in commodity taxes and subsidies that is proportionally in the direction of the first bestcan be implemented in a manner that produces a Pareto improvement. Third, a conceptuallysimple necessary and sufficient condition is offered that indicates which other commodity taxreforms make possible Pareto improvements. Section 5 discusses some of the principalqualifications and explains why the present results diverge so substantially from those in mostprior work. Section 6 offers concluding remarks.Before proceeding, it is useful to relate the present analysis and results to two additionalstrands of literature. The first pertains to the method of proof employed here, which involves anadjustment to the preexisting income tax such that the reform as a whole (combining the incometax adjustment to the proposed modification of commodity taxes) is distribution neutral. Thisfollows Hylland and Zeckhauser (1979), Kaplow (1996), and some subsequent work that focuseson public goods. (Although Kaplow (1996, 2004) has discussed the application of this approachto the regulation of externalities,