Optimal taxation of externalities interacting through markets: A theoretical general equilibrium analysis

This study develops a theoretical general equilibrium model to examine optimal externality tax policy in the presence of externalities linked to one another through markets rather than technical production relationships. Analytical results reveal that the second-best externality tax rate may be greater or less than the first-best rate, depending largely on the elasticity of substitution between the two externality-generating products. These results are explored empirically for the case of greenhouse gas and nitrogen emissions associated with biofuels and petroleum.

Research highlights▶ Given two externalites connected through their sources which are substitutes in the market, the optimal tax rate for one externality could be higher or lower than its first best tax rate, depending on the nature of the distortion in the other externality and the interactions between the final goods. ▶ Under the assumption that gasoline and ethanol are close substitutes, GHG tax increases nitrogen leaching. ▶ The parameter related to market interactions is the most important in determining the effects of one tax on the other externality.