Abstract: Optimal policy analysis is complicated by problems of the second best. Two of the most important problems — non-ideal distribution and labour supply distortion — are intimately connected with limitations of income taxation. In a first-best world, individualized lump-sum taxes can be used to achieve any desired distribution without causing distortion. Accordingly, the optimal design of other government policies is dictated by familiar firstbest rules: the Samuelson cost-benefit test for public goods, the Pigouvian prescription for externalities to equate the full marginal social costs and benefits, marginal cost pricing for publicly provided goods and services and for regulated utilities, and so forth.