Some principles for corrective taxation of externalities in a second-best world with commodity taxes

Sushama Murty ()

Centre for International Trade and Development, Jawaharlal Nehru University, New Delhi Discussion Papers from Centre for International Trade and Development, Jawaharlal Nehru University, New Delhi, India

Abstract: Some principles for the design of commodity-taxes are derived, when they are employed for correcting externalities in addition to meeting the conventional revenue and redistributive objectives of the government. With production externalities, production efficiency is violated at the second-best, which involves intermediate-input taxation of (i)the externality-causing good directly, or (ii)“non-substitutable inputs” or outputs produced by them in manufacturing chains that include the externality-generating goods, or (iii)commodities whose use as inputs is complementary to the input usage of goods that generate externalities, or (iv)some combinations of (i)–(iii). Second-best consumption taxes have two independent and additive components: (a)a conventional equity and efficiency-balancing “many person Ramsey rule”(MPRR)-based VAT or GST and (b)an “externality-correcting” excise duty. The externality components of both consumption and optimal intermediate-input taxes are linked and cannot be chosen independently, although there exist several degrees of freedom in selecting them at a second-best. The optimal VAT is zero for commodities with indirectly-derived demands such as electricity, motoring-fuel, and road-services. The input-tax credit to a producer, who pays retail price for an intermediate-input, is equal to the GST plus the excess of the externality-excise component of the consumption tax over the corresponding intermediate-input tax. Many real-life commodity-tax policies are compared with our resultsLength: 48 pages

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