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The Present Value Criterion and Environmental Taxation: The Suboptimality of First-Best Decision Rules

This paper examines the links between environmental taxes and distortionary taxation in a dynamic model of climate change and economic growth. Under first-best conditions, labor and capital would remain untaxed, and carbon dioxide emissions would be taxed at a rate equal to the present-value marginal cost they impose on future society, setting the discount rate equal to the marginal productivity of capital. Under second-best conditions, however, this decision rule substantially understates optimal emissions taxes when the resulting revenues are used to provide targeted cuts in distortionary taxes. Conversely, relatively low emissions taxes are economically justified given lump-sum revenue recycling. (JEL Q53, Q58)