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Second-Best Optimal Emission Pricing

Author

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  • Ross McKitrick

    (Department of Economics and Finance, University of Guelph, Guelph ON Canada)

Abstract

The classical Pigovian analysis leads to the “polluter pay” concept, in which firms pay the marginal damages (MD) of their emissions, evaluated where MD equals marginal abatement costs (MACs). But Sandmo (1975) showed that the emission tax rate should be normalized by the marginal social cost of the tax system or it will lead to a suboptimal outcome. This insight implies a distinction between private and social MACs, the implication of which is largely ignored in environmental policy textbooks and in practice. Here I review the underlying theory, provide a simple graphical summary and then offer a formal derivation in general equilibrium. The Pigovian and Sandmo pricing rules can be reconciled by noting that tax distortions drive a wedge between private and social MACs and the Sandmo rule compensates for the difference. I discuss some of the practical implications and surprising paradoxes created by the Sandmo analysis. I then present a detailed discussion of how the Sandmo model can be applied to the development of optimal climate policy.

Suggested Citation

  • Ross McKitrick, 2024. "Second-Best Optimal Emission Pricing," Working Papers 2403, University of Guelph, Department of Economics and Finance.
    • Handle: RePEc:gue:guelph:2024-03
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    File URL: http://www.uoguelph.ca/economics/repec/workingpapers/2024/2024-03.pdf
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    More about this item

    Keywords

    Green taxes; Pigovian rule; Sandmo model; tax interactions; damage thresholds; climate policy;
    All these keywords.

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy

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