Economic Impacts of Environmental Policies.

• Author: Goulder, Lawrence H.

Lawrence H. Goulder [*]

Over the last three decades in the United States and other nations, there has been a significant increase in the use of economic analysis to guide the design and evaluation of environmental policies. Economic analysis has played a key role in the evaluation of "green tax reform" -- the reorienting of the tax system to concentrate taxes more on "bads" like pollution and less on "goods" like labor effort or capital formation (saving and investment). Economic analysis also has guided the design of innovative new approaches to environmental regulation that hold the promise of achieving environmental goals at lower cost than is possible under conventional regulations. And, it has been used to map out how the impacts of environmental policies are distributed across industries and household groups--a consideration that is highly relevant to the political feasibility of environmental initiatives.

Much of my research focuses on these sorts of environmental policy issues. I often use a general equilibrium framework, an approach that considers how environmental policies affect not only the targeted firms or industries but the rest of the economy as well. General equilibrium analysis yields dramatically different results from what one would obtain from partial equilibrium, or sector-specific, analyses. In realistic, "second-best" economies with pre-existing distortionary taxes, such as income and sales taxes, the differences are striking. In some cases, policies that appear to improve efficiency in a partial equilibrium analysis emerge as reducing efficiency when researchers account for second-best, general equilibrium interactions. Moreover, general equilibrium interactions sometimes alter the relative costs of different environmental policy options, overturning the conventional wisdom that regulatory approaches are the most cost effective. [1]

Environmental Tax Reform and the "Double Dividend"

Green tax reform usually involves substituting environmentally motivated ("green") taxes for existing distortionary ones, for instance income and sales taxes. One highly debated green tax reform is the introduction of a revenue-neutral carbon tax: levying taxes on fossil fuels according to their carbon content and using the additional tax revenues to finance reductions in income tax rates. The carbon tax would also confront the prospect of global climate change by discouraging combustion of fossil fuels and the associated emissions of carbon dioxide ([CO.sub.2]), a principal contributor to the greenhouse effect.

The possibility of using green tax revenues to finance cuts in marginal rates of existing distortionary taxes is also attractive in terms of efficiency. This has prompted speculation as to whether the revenue-neutral substitution of environmental taxes for other taxes might offer a "double dividend": not only improving the environment but also reducing the overall cost of the tax system.

If the second "dividend" obtains, then the gross costs (that is, the costs apart from environmental benefits) of the reform are zero or negative. Proponents of revenue-neutral green tax reforms would welcome this result, since it implies that policymakers must only establish that there are positive benefits to the environment from the reforms in order to justify them on efficiency grounds. This is especially important in regards to the carbon tax, given the vast uncertainties about the magnitudes of the environmental benefits (the avoided damages from climate change) that this policy generates.

A FIRST GLIMPSE

Does the double dividend indeed arise? Using revenues from green taxes to finance cuts in distortionary taxes does avoid some of the distortions that these pre-existing taxes would generate otherwise. This implies an efficiency benefit, which is termed the "revenue-recycling effect." Because of the positive revenue-recycling effect, the costs of a green tax reform will be lower when the revenues from such a tax are used to finance cuts in distortionary taxes than when the revenues are returned to the economy in a lump-sum fashion--for example, through lump-sum transfers to households. However, this simply means that the costs of the former policy are lower than the costs of the latter policy; it does not mean that those costs are negative, which is the requirement for the second dividend to occur.

Are the costs of the green tax negative? Over the last decade, many researchers have addressed this question. [2] The simplest analytical models suggest that the answer is no. [3] These models point out that green taxes usually are a relatively inefficient way to raise revenue: the economic cost of raising a dollar through green taxes tends to be higher than that of raising a dollar through ordinary income taxes. Intuitively, that is because green taxes have a much narrower base than income taxes. They focus on individual commodities (such as fossil fuels) or on emissions from particular industries. As a result, they tend to imply larger "distortions" [4] in markets for intermediate inputs, for consumer goods, and for labor and capital, Hence, swapping a green tax for part of the income tax augments the (nonenvironmental) distortions of the tax system, and there is an economic cost of this revenue-neutral tax reform.

A CLOSER LOOK

Separating out three components of the overall cost of a...