The marginal cost of funds in the presence of external effects

Abstract

The Marginal Cost of Funds (MCF) is useful in cost-benefit and tax reform analysis. This paper presents general equilibrium estimates of the MCF in an economy with environmental external effects. Environmental externalities affect the estimates in the following way: If increased taxes leads to substitution away from activities that have external effects, then the estimate of the MCF will be lower than would have been the case otherwise. Substitution into activities with external effects will increase the estimate of the MCF. Environmental externalities are uncertain. We treat them as random variables to account for the uncertainty. Our results indicate that the "base-case" estimate of the MCF is reduced by around 0.2 when environmental externalities are taken into account. The impact of externalities however depends greatly on which tax is being used to increase public revenue. This indicates a significant potential for tax reform.