Louis Kaplow (Harvard) has posted Optimal Control of Externalities in the Presence of Income Taxation on SSRN. Here is the abstract:

A substantial literature examines second-best environmental policy, focusing particularlyon how the Pigouvian directive that marginal taxes should equal marginal external harms needsto be modified in light of the preexisting distortion due to labor income taxation. Additionalliterature is motivated by the possibility that distributive concerns should amend theinternalization prescription. It is demonstrated, however, that simple first-best rules – unmodified for labor supply distortion or distribution – are correct in a natural, basicformulation of the problem. Specifically, setting all commodity taxes equal to marginal harms(and subsidies equal to marginal benefits) can generate a Pareto improvement. Likewise, amarginal reform in the direction of the first-best can yield a Pareto improvement. For otherreforms, a simple efficiency test characterizing when a Pareto improvement is possible is offered. Qualifications and explanations for the substantial departure from results in previous work arealso elaborated.