The Economics of Environmental Taxes: Using First-Best Models in a Second-Best World

EPA Grant Number: R829582
Title: The Economics of Environmental Taxes: Using First-Best Models in a Second-Best World
Investigators: Howarth, Richard B.
Institution: Dartmouth College
EPA Project Officer: Hahn, Intaek
Project Period: January 1, 2002 through December 31, 2003
Project Amount: $67,887
RFA: Market Mechanisms and Incentives for Environmental Management (2001) RFA Text |  Recipients Lists
Research Category: Environmental Justice


Economists have emphasized the potential role of greenhouse gas (GHG) emissions taxes in achieving the goals of the Framework Convention on Climate Change. In gauging the potential impacts of such taxes on the U.S. and world economies, analysts often use "first-best" models of the interaction between public policies and the market decisions of households and firms. Such models abstract away from the structure of the existing tax system, equating the marginal costs and benefits of emissions abatement to achieve economic efficiency. In recent years, theoretical research has established that environmental taxes interact with existing taxes on income and returns to capital. The "common wisdom" now holds that first-best models may overstate optimal GHG taxes and emissions control rates. The proposed research will carefully assess this question by exploring the links between a standard first-best model and a related second-best model in which distortionary taxes impair economic efficiency. First-best models choose rates of time preference (or discount rates) based on the pre-tax returns generated by capital investment. Pre-tax returns, however, are substantially higher than the after-tax returns that, in theory, reveal decision-makers' true preferences regarding intertemporal tradeoffs. Hence first-best models both overlook the impacts of existing taxes and discount the future at an excessive rate.


The project will revise and recalibrate economic models of climate change and the world economy, comparing the optimal GHG taxes that arise when (a) the existing structure of taxation is omitted from consideration, and (b) the model incorporates realistic assumptions concerning taxes and public expenditure and the response to these policies by market participants.

Expected Results:

Preliminary calculations suggest that first-best models may understate optimal GHG tax rates by as much as 60%. This conclusion, however, is based on simplified assumptions that require further analysis. The project will provide benefits by improving the methods used to evaluate the economic impacts of environmental taxes. Such analysis is of significant importance in discussions of climate change response strategies at the national and international levels.

Publications and Presentations:

Publications have been submitted on this project: View all 11 publications for this project

Journal Articles:

Journal Articles have been submitted on this project: View all 2 journal articles for this project

Supplemental Keywords:

global climate, public policy, market mechanisms and incentives, distortionary taxation., RFA, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, Air, Ecology, Chemistry, climate change, Social Science, Market mechanisms, environmental monitoring, financial mechanisms, policy instruments, effects of policy instruments, policy making, impact of federal policy instruments, government intervention, economic models, environmental taxation, pollution fees, environmental impact fees, green house gas taxes, cost effective, ecosystem sustainability, global warming, tax interactions, first-best models, environmental economics

Progress and Final Reports:

  • 2002
  • Final Report