Is There a Principle of Targeting in Environmental Taxation?

Abstract

We test whether the principle of targeting (alternatively Sandmo’s (1975) additivity property and Kopczuk’s (2003) decomposition involving the Pigovian rule) has relevance for environmental taxation in a second best world consisting of an exogenous revenue requirement and pre-existing distortionary taxes. In the context of differentiated commodity taxes, we find that Sandmo’s additivity property breaks down once one solves explicitly for the marginal cost of public funds (MCPF). Further, in the more realistic setting of a uniform commodity tax and a dedicated emissions tax, we find that the additivity property no longer holds even in the form Sandmo studied it, i.e. without solving explicitly for the MCPF. Finally, we argue that Koczuk’s decomposition is not persuasive, as it requires that a second government agency must apply a corrective tax or subsidy to adjust the choice of the Pigovian rule by the environmental agency. In a same-numbers exercise (i.e. the number of tax instruments is not increased), we show that there is no presumption in favour of a direct emissions tax over a uniform commodity tax; rather, the choice depends upon the size of the environmental damages. We conclude that there does not exist a principle of targeting in environmental taxation.environmental taxation; second best; principle of targeting