March 6, 2011

Pigou Meets Mirrlees: On the Irrelevance of Tax Distortions for the Second-Best Pigouvian Tax

by Bas Jacobs and Ruud A. de Mooij

- This paper extends the Mirrlees (1971) model of optimal income redistribution with optimal corrective taxes to internalize consumption externalities. It is demonstrated that the optimal second-best tax on an externality-generating good should not be corrected for the marginal cost of public funds. The reason is that the marginal cost of public funds equals unity in the optimal tax system, since marginal distortions of taxation are equal to marginal distributional gains. The Pigouvian tax needs to be modified, however, if polluting commodities or environmental quality are more complementary to leisure than non-polluting commodities are.

Jacobs, B. and R.A. de Mooij (2011). "Pigou Meets Mirrlees: On the Irrelevance of Tax Distortions for the Second-Best Pigouvian Tax." CESifo Working Paper No. 3342, Feb 2011.