Externality policy reform: a general equilibrium analysis

We characterize Pareto-improving and equilibrium-preserving policy reforms in a second-best (Diamond/Mirrlees) world with a consump-tion externality. A counterintuitive finding is that, starting from an initial equilibrium with no direct quantity control on the externality, it is possible that all Pareto-improving and equilibrium-preserving directions of change require an increase in a negative externality. We provide intuition for these results by establishing a nexus between Guesnerie’s approach to designing (tax) policy reforms and the stan-dard Kuhn–Tucker technique for identifying the manifold of feasible Pareto-optimal states, given the instruments available to the policy maker. 1