Second-Best Optimal Emission Pricing

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.