Optimal emission tax with pre-existing distortions

In contrast to the previous literature, this paper examines the optimal second-best environmental tax rate in the presence of pre-existing distortions by taxing emissions rather than commodities. First, by extending the general equilibrium model in the literature, we find that the “Ramsey” formula is different from the traditional one. Both the magnitude of the optimal emission tax rate and the welfare effects of the green tax reform depend on the stage of labor supply curve in which the labor tax is. Second, we analyze other tax systems that are not mentioned in the literature. In a tax system with an environmental tax and an abatement subsidy, the welfare effects of increasing or decreasing the two policy instruments at the same time will be negative.