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OPTIMAL CONTROL OF EXTERNALITIES IN THE PRESENCE OF INCOME TAXATION



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ISSN 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 JEL Classes D61 D62 D63 H21 H23 K32 Optimal Control of Externalities in the Presence of Income Taxation Louis Kaplow Abstract A substantial literature examines second best environmental policy focusing particularly on 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 is motivated by the possibility that distributive concerns should amend the internalization prescription It is demonstrated however that simple first best rules unmodified for labor supply distortion or distribution are correct in a natural basic formulation of the problem Specifically setting all commodity taxes equal to marginal harms and subsidies equal to marginal benefits can generate a Pareto improvement Likewise a marginal reform in the direction of the first best can yield a Pareto improvement For other reforms 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 are also elaborated First Draft June 2004 Revised Draft June 2006 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 for comments and to the John M Olin Center for Law Economics and Business at Harvard University for financial support Optimal Control of Externalities in the Presence of Income



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