Externalities and partial tax reform: Does it make sense to tax road freight (but not passenger) transport?

Externalities such as pollution and road congestion are jointly produced by the use of intermediate inputs by firms and the consumption of final goods by households. Remarkably, to cope with such externalities policy proposals often suggest very partial tax reforms. A pertinent example is the current EU proposal to introduce congestion taxes for freight transport on major roads while, for political or technical reasons, failing to similarly address passenger transport. This paper uses a simple general equilibrium model to explore the effects of such a partial tax reform in a second-best setting. The theoretical model shows that the welfare effect of higher freight taxes is positive, unless passenger transport is severely under-taxed and the tax reform attracts substantially more passenger transport. Moreover, the optimal freight tax may be below or above marginal external cost; the former holds if passenger transport is under-taxed and the freight tax does not strongly affect labour supply. Budgetary neutral tax reform exercises with a numerical simulation model for the UK suggest that, under a wide variety of parameter values, higher freight transport taxes are indeed welfare increasing. The welfare gain of freight tax reform rises with the level of the passenger tax, but the optimal freight tax declines at higher taxes on passenger transport. Substantial net benefits of tax reform are obtained only under labour tax recycling of the revenues.