Correcting externalities through taxes on/subsidies to related goods

Abstract Optimal corrective taxation is considered in the presence of externalities in cases where only related goods, i.e. complements to or substitutes for externality-creating goods, can be taxed. In the context of identical individuals and separable externalities, taxing and subsidizing complements and substitutes to externalities are analyzed. First, the circumstances under which it is optimal to operate on one market only for a related good are examined. Second, cases are identified where optimality requires taxes on substitutes for (or subsidies to complements to) a good which generates negative externalities.