Reconsidering Environmental Taxation and Optimal Policy (Dallas Burtraw, Resources for the Future, presiding) OPTIMAL ENVIRONMENTAL TAXATION FROM SOCIETY’S PERSPECTIVE

Much has been made recently of compar-isons between the optimal environmental tax and the marginal social damage from pol-lution when moving from a first-best set-ting to a second-best setting involving distor-tionary taxes (Bovenberg and de Mooij, Parry, Bovenberg and Goulder). Generally speaking, the recent literature observes that results for a first-best setting may not be valid in a second-best setting. The present analysis finds that this same general theme applies when defin-ing social values and, in particular, when ex-pressing the social marginal rate of substitution (MRS) between the environment and income on which the definition of marginal social dam-age (MSD) is based. We find that a commonly used expression for MSD involving the sum of individuals ’ private marginal rates of substitu-tion between the environment and income is only equal to the social MRS at the first-best optimum. In a second-best setting with distor-tionary taxes, this expression is no longer equal to the social MRS and thus does not provide a consistent measure of relative values from society’s perspective. When MSD is defined based on general an-alytical expressions for the social MRS (ones that are valid in both first-best and second-best settings), the optimal environmental tax is found generally to rise above MSD as we move from a first-best to a second-best setting. These results are fully consistent with the intuition of “revenue recycling ” and the “double-dividen