This paper develops an analytical framework for assessing the second-best optimal level of gasoline taxation, taking into account unpriced pollution, congestion, and accident externalities and interactions with the broader fiscal system. We provide calculations of the optimal taxes for the United States and the United Kingdom under a wide variety of parameter scenarios, with the gasoline tax substituting for a distorting tax on labor income.
Under our central parameter values, the second-best optimal gasoline tax is $1.01 per gallon for the United States and $1.34 per gallon for the United Kingdom. These values are moderately sensitive to alternative parameter assumptions. The congestion externality is the largest component in both nations, and the higher optimal tax for the United Kingdom is due mainly to a higher assumed value for marginal congestion cost. Revenue-raising needs, incorporated in a “Ramsey” component, also play a significant role, as do accident externalities and local air pollution.
The current gasoline tax in the United Kingdom ($2.80 per gallon) is more than twice this estimated optimal level. Potential welfare gains from reducing it are estimated at nearly one-fourth the production cost of gasoline used in the United Kingdom. Even larger gains in the United Kingdom can be achieved by switching to a tax on vehicle miles with equal revenue yield. For the United States, the welfare gains from optimizing the gasoline tax are smaller, but those from switching to an optimal tax on vehicle miles are very large.