Coping with Externalities in Tourism: A Dynamic Optimal Taxation Approach

Abstract

The paper studies optimal taxation (subvention) when tourism is associated with ‘multiple externalities’, using a simple dynamic model of a small open economy specializing completely in the production of tourism services and populated by a large number of intertemporally optimizing agents. Depending on the volume of tourism production, the externality can be either positive or negative. The study shows that the first best optimum, achieved by a central planner recognizing the externality, can be replicated in a decentralized economy by using a time-varying tax rate. This ensures (i) that the steady state of the first best optimum is reached and (ii) that the speed of convergence to steady state is socially optimal.