Edited by Emilio Albi and Jorge Martinez-Vazquez
Chapter 8: The Scale and Scope of Environmental Taxation
* Agnar Sandmo 1 INTRODUCTION One of the first lessons that new students of economics learn about the principles of public finance is that indirect or commodity taxes are harmful to the efficiency of the economy. The partial equilibrium analysis that forms the basis for this conclusion is a simple and compelling one: a commodity tax drives a wedge between the marginal cost of production (as represented by the supply curve) and the marginal consumer benefit (as represented by the demand curve). The tax therefore prevents the market mechanism from reaching the efficient equilibrium solution where marginal cost is equal to marginal benefit. In a later lesson the student may learn that there are exceptions to this rule. If there are negative externalities associated with the production or consumption of a particular commodity – the typical example being adverse effects on the quality of the environment – efficiency may in fact be improved by taxation. Suppose, for the sake of the argument, that the externality in question generates a positive difference between social and private marginal cost, while private and social marginal benefits coincide. The requirement for efficiency is that the social marginal cost of production should be equal to the social marginal benefit, which again is equal to the private marginal benefit: SMC 5 SMB 5 PMB. Suppose further that this market operates according to the principles of perfect competition except that the market prices with which producers and consumers are faced are allowed to differ. Producers, who are assumed to maximize...
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