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Optimal Taxation and Environmental Policy in a Decentralized Economic Federation with Environmental and Labor Market Externalities

PFM, Vol. 10 No. 2, (2010)

This paper concerns optimal taxation and environmental policy in the presence of transboundary environmental damage and labor market distortions, where the latter gives rise to wage bargaining externalities between countries. I consider a decentralized economic federation where the federal government chooses emission targets to be implemented by the national governments. The results show that the labor market externality will influence the target levels for emissions chosen by the central government. I then proceed to characterize the optimal tax policy at the national level. The decentralized federation structure produces incentives for the national governments to use the tax policy to influence the policies chosen by the federal level. It is shown how these objectives inter-act with the additional objective to minimize the distortion on the national labor market.

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