Abstract:

In a first-best world with lump-sum taxes, a uniform tax levied across poluting activities minimizes the costs of achieving an environmental standard. This so-called price-standard approach may no longer apply when distortionary taxes pre-exist. Imposing a lower tax on price-elastic activities as current energy tax schemes propose may be welfare improving. This paper shows, however, that the price-standard approach even holds in a second-best world where revenues from environmental taxes are used to reduce a pre-existing distortionary labor tax. Rather surprisingly, the environmental benefits of a higher tax rate for a price-elastic polluting activity are exactly offset by the costs of a higher tax distortion, provided all pollution activities are subject to the same tax rate.