Abstract
Should externality taxes be reduced if they are regressive? We introduce a model in which the government raises revenue from distortionary income and commodity taxes which also play an externality correction role. Whether the tax on the externality should be adjusted away from the Pigouvian level of marginal damage depends on why households differ in their consumption patterns. Differences in demand due to preference heterogeneity across the income distribution change the optimal tax, while differences due to income effects do not. We derive sufficient statistics for optimal policy, and use them to study the optimal tax on carbon-intensive consumption in the United States. Our empirical results suggest that the carbon tax should be set only slightly lower than the Pigouvian level. When we allow for heterogeneity in preferences at each income level as well as across the income distribution, our recommended carbon tax moves even closer to the Pigouvian benchmark.