Product Quality and Environmental Taxation
Paper number: 00/10
Paper date: July 2000
Paper Category: Working Paper
Gareth D. Myles and Ayse Uyduranoglu
In developed countries, car use is one of the most significant contributors to air pollution. It is also a notable fact that larger, heavier cars consume more fuel and hence contribute more to pollution. This observation has lead to policy proposals to structure taxation to encourage the use of smaller, lighter cars. A model of vertical product differentiation is used to explain why different types of car are chosen. The correct policy response to the externality problem is then investigated using this model. It is shown that there are reasons why the standard policy response may be flawed and that it may even be optimal to subsidize large cars at the expense of small. A comparison of policies reveals that the relative merits of differentiated annual taxes and differentiated fuel taxes are dependent on the degree of income inequality.