1. INTRODUCTION
An extensive literature has analysed optimal taxation and tax reform in the
presence of externalities in a second-best framework. Most papers assume that
environmental quality enters the utility function in a separable way and therefore ignore
the feedback effect of environmental quality on the behaviour of the economic agents.
In a number of recent studies the implications of taking into account the feedback
effects are considered. These include Mayeres and Proost (1997, 2001), Schwartz and
Repetto (2000) and Williams (2002, 2003).
Mayeres and Proost (1997) derive optimal tax rules in the presence of an
externality with a feedback effect for an economy with distortionary taxes. The
externality is assumed to enter the utility function in a non-separable way. Moreover, it
leads to productivity losses in the production sectors. They show that the optimal tax on
an externality generating good equals the sum of a revenue-raising component and the
net social Pigouvian tax. The net social Pigouvian tax takes into account the damage
imposed by the externality on consumers and producers. Moreover, it is shown that,
ceteris paribus, the net social Pigouvian tax will be smaller if a higher level of the
externality leads to more consumption of the taxed commodities. Williams (2002)
demonstrates that the welfare effect of an externality tax consists not only of a tax
interaction and revenue recycling effect, two well-known effects, but also of a benefit
side tax interaction effect. Whether this last effect exacerbates or mitigates the pre-
existing distortions depends on the effects of air pollution. Williams considers four
possible routes through which air pollution may affect the pre-existing distortions. First,
if improved air quality leads to less medical spending, this creates an income effect that
reduces labour supply, thereby worsening existing distortions. Secondly, if better air
quality reduces time lost to illness, the benefit side tax interaction effect is ambiguous.
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