A Fuel Tax Decomposition When Local Pollution Matters

We study the optimal design of consumption taxes when both global and local externalities matter. Local externalities make the social impact of the consumption of externality-generating commodities varying across consumers. A typical example involves the greater damage caused by pollution from urban fuel consumers. We provide a condition for the validity of the targeting principle according to which externality concerns should only fall on the taxes on externality-generating commodities. When this condition is satisfied, one can decompose the tax on an externality-generating commodity into equity/efficiency and Pigovian contributions. The Pigovian contribution should exceed the average social damage if the fuel consumption of the greatest polluters is more responsive to fuel price. In an empirical illustration we find that the fuel tax in France is mostly explained by Pigovian considerations