Optimal tax policy under heterogeneous environmental preferences

•We model a federation of K jurisdictions where agents value consumption vs. nature differently.•First-best efficiency is obtained with the combination of pollution tax rates and lump-sum transfers.•The optimal tax rates depend only (but in a non-trivial way) on the externality parameters.•For arbitrary preferences optimal transfers depend on regions' preferences and stocks of nature.

We model an economy of K heterogeneous regions where agents value consumption vs. nature differently. Consumption obtained through pollution-inducing production also generates a negative externality on neighbors. We show that even with a decentralized policy we can obtain first-best efficiency by choosing a combination of pollution taxes in both regions and lump-sum transfers. Moreover, we show that optimal pollution taxes are determined only by the externality parameters, independent of agents' preferences for consumption and nature.