Second-best carbon taxation in a differentiated oligopoly

Diego S. Cardoso.


Corrective environmental taxes typically equal the value of marginal damages. This approach maximizes social welfare when an environmental externality is the only market imperfection. When multiple imperfections exist, however, estimates of marginal damage are not sufficient to set an optimal tax: it is also necessary to understand the market structure and estimate the effect of imperfections such as market power and distortionary taxes. This paper estimates the optimal carbon tax for US domestic aviation by combining a theoretical framework of optimal environmental taxation and structural econometric methods for the study of oligopolies. Based on a structural model and sufficient statistics, I estimate marginal and total costs of emission abatement via carbon taxation, calculate the optimal carbon tax in the presence of non-carbon distortions, and examine the extent to which existing taxes are substitutes for a carbon tax. Estimates indicate that the current marginal abatement cost of carbon taxation is between $210 and $277/ton CO2. Hence, if the social cost of carbon (SCC) is smaller than this value, any positive carbon tax would decrease social welfare. Under a higher SCC of $300/ton CO2, the optimal carbon tax is $107/ton CO2, thus much lower than the Pigouvian tax level. Moreover, the current sales taxes on air travel correspond to an average carbon tax of approximately $61/ton CO2. Implementing a revenue-neutral carbon tax to replace current taxes could lead to welfare gains but increase emissions due to the implied subsidization of cheaper and fuel-efficient flights with sales tax.