Optimal Tax Policy with Environmental Externalities and Heterogeneous Preferences

Abstract

This study considers simultaneously two important aspects of taxation, environmental policy and redistribution. Tax policy is constrained by the a symmetric information of agents’ productivities and preferences. Two-dimensional heterogeneity affects the optimality of commodity taxation: it can be used to redistributional or environmental purposes, but there seems to be a trade-off between these objectives. However, the contradiction between the two aspects is not as clear as in the case with identical consumer preferences. It is also shown that the Sandmo-Dixit result of these parability of environmental taxes fails with two-dimensional heterogeneity in the pool ingoptimum, but not in these parating optimum. The explanation to this is that there are too few policy instruments in the pooling equilibrium: commodity taxes should take care of both redistribution and externality internalisation.