<p>This paper analyzes the taxation of emissions in the presence of two institutional frictions common in developing countries. First, credit markets are underdeveloped in terms of both access to credit and borrowing conditions. Second, limited state capacity restricts the operation of the tax system. The analysis shows that the second-best emissions tax reflects both marginal environmental damages, as in the Pigouvian principle, and the effectiveness of taxation in reducing pollution. Credit market frictions hinder the adoption of clean technologies and increase emissions, which would, in isolation, call for a higher Pigouvian tax. However, these frictions may also reduce the responsiveness of emissions to taxation by limiting firms’ ability to adopt cleaner technologies, thereby lowering the optimal second-best tax. To capture these mechanisms, the paper distinguishes between two types of distortions: collateral-based, productivity-independent differences in access to credit, and cash-flow–based borrowing constraints. The optimal tax responds differently to each type of distortion.</p>