Optimal tax policy in the presence of productive, consumption, and leisure externalities

•Optimal taxes on capital and labor are constant. Consumption tax is time varying.•When all externalities are positive, only labor income must be taxed.•Optimal taxes on consumption and capital are independent of the leisure externality.•Leisure externalities play a central role in reducing existing market distortions.

This paper presents the optimal tax policy in an economy featuring consumption, production, and leisure externalities. This extends prior models that only consider consumption and production externalities. The immediate consequence is labor income should be taxed (subsidized) if the leisure externality is positive (negative). In addition, numerical simulations show that in the presence of positive production externalities, and irrespective of the sign of consumption externalities, an increase in the importance of the leisure externality reduces the distortion generated by consumption and production externalities. This effect is reversed if production externalities are negative.