University of California Energy Institute

This paper develops an analytical framework to assess the second-best optimal level of gasoline taxation taking into account unpriced pollution, congestion, and accident externalities, as well as interactions with the broader fiscal system. We provide calculations of the optimal taxes for the US and the UK under a variety of parameter scenarios.

Under our central parameter values, the second-best optimal gasoline tax is $1.01/gal for the US and $1.34/gal for the UK. Current tax rates are much lower than this in the US and higher in the UK. The calculations are moderately sensitive to alternative parameter assumptions. The congestion externality is the largest component in both nations; revenue-raising needs also play a significant role, as do accident externalities and local air pollution.

Potential welfare gains from reducing the current UK tax rate are estimated at nearly one-fourth the production cost of all gasoline used in the UK. Even larger gains could be achieved by switching to a tax on vehicle miles with equal revenue yield. For the US, the welfare gains from optimizing the gasoline tax are smaller, but those from switching to an optimal tax on vehicle miles are very large.