Optimal Mixed Taxation and Multiple Externalities

Abstract: This paper explores the optimal policy rules for mixed taxation in a static economy with multiple externalities, where there is asymmetric information between the government and individuals. Our main contribution is to characterize the optimal commodity and marginal income tax structure under different assumptions about externalities and the available tax instruments. The exploration starts with our benchmark model with atmospheric positional and environmental externalities, accessible linear commodity and non-linear income taxes as well as two ability-type consumers. The outcome shows that the marginal value of externalities enters additively into the commodity tax formula without altering the policy rule for marginal income taxation. The analysis surveys two scenarios (the failure of implementing a tax on the positional commodity and upward comparisons) of how other taxes become indirect instruments to correct for the positional externality when the tax on the positional commodity does not fully internalize the positional externality. The results also imply that cross-price effect between two externality-generating commodities matters in the whole tax system.