Green taxes: can we protect the environment and improve the tax system at the same time?

• Author: Oates, Wallace E.

1. Introduction

   On a cursory inspection, public economics appears to provide a straightforward and compelling answer of YES to the question posed in the title to this paper. As economists have long argued, appropriately designed taxes can, in principle at least, efficiently restrain levels of polluting activities. And, in addition, such taxes will generate revenues so that we can reduce rates on other forms of taxation that distort the functioning of the economy. Green taxes, in short, promise a "double dividend": they can both reduce excessive levels of pollution and increase the efficiency of the overall tax system. At least, so several economists have argued recently [17; 20].

   But is this really so? With the growing recognition of the enormous revenue potential of certain environmental taxes (especially carbon taxes to address the problem of global warming), public economists have returned to this question with a new round of research efforts directed both to understanding the properties of pollution taxes as revenue sources and to estimating their revenue potential and the magnitude of their effects on the economy. And the newly emerging literature is producing some quite astonishing and very troubling findings.(1)

   In this paper, I want to review this work and explore its implications. When viewed in relation to some other research, it appears to suggest that most forms of regulatory activity (at least those that increase the costs of the regulated activities) may have hitherto unappreciated costs of a stunning magnitude. What many of us would have taken to be "second-order side effects" of environmental and other regulatory policies can be of a magnitude that compromises to a significant extent their welfare-enhancing properties. Having reviewed this body of work, I wish also to explore some issues in the political economy of green taxes. It is helpful to begin by briefly putting the issue in historical perspective.

2. Some Background

   The early work on Pigouvian taxes or charges essentially ignored the revenue issue. The assumption, either explicit or implicit, was that the revenues would somehow be returned to the economy in lump-sum fashion so as not to cause any distortions in economic activity. The one qualification in this literature is that the revenues must not be used to compensate victims for the damages they suffer from polluting activities, for such compensation would compromise the incentives for efficient levels of defensive activities by victims. But, for our purposes here, the essential point is that the early literature (with the important exceptions of Agnar Sandmo [22; 23] and Yew-Kwang Ng [16]) gave little serious attention to Pigouvian taxes as a source of public revenues.(2)

   A later strand in the literature took up this issue. David Terkla [27] actually estimated the potential efficiency gains from substituting revenues from a hypothetical set of nationwide taxes on particulate and sulfur oxide emissions for revenues from federal income (or alternatively corporate income) taxes. Using an optimal tax framework, Dwight Lee and Walter Misiolek [14] explored the determination of pollution tax rates to maximize the efficiency gains. Drawing on such work, observers advanced the seemingly compelling intuitive case for a "double dividend" from pollution taxes. Not only can such taxes raise social welfare by reducing polluting activities to (or at least toward) their efficient levels, but they can give us an improved revenue system by reducing reliance on income, sales, and other distorting taxes. Pollution taxes, in short, can give us both enhanced environmental quality and a better tax system.

3. Is There a Double Dividend?

   But things do not turn out to be quite this simple. As often happens when we enter the murky waters of the second-best, our economic intuition is not a very reliable guide. In this instance, we find that, in the presence of existing distortions, the introduction of pollution taxes can itself exacerbate these distortions with a resulting increase in the level of excess burden. And the striking result in the new literature is that this effect can easily outweigh the efficiency gains from recycling the revenues so as to reduce rates on existing taxes. Thus, there may be no double dividend.(3)

   There are certainly instances where a double dividend exists. Sandmo [24] cites an especially transparent case. Suppose that the revenues from pollution taxes set equal to marginal social damage provide sufficient funds to finance the entire public budget. Then, of course, all distorting taxes can be done away with. And we will achieve both efficient levels of externality-generating activities and a revenue system with no excess burden. Here there is clearly a double dividend from the introduction of environmental taxes. But, more generally, where pollution taxes must exist alongside distorting levies, the various economic linkages between the demands for different goods and in their production will typically be the source of additional excess burden.

   To get a better sense of this, consider a case where there exist taxes on labor income (as in the seminal paper by Bovenberg and de Mooij [3]). There is thus a distortion in the work-leisure choice (assuming that the compensated labor supply function is not perfectly inelastic). A tax on polluting waste emissions in the production of various goods will raise the price of these goods, thereby reducing the return to work effort and inducing a substitution of additional leisure for consumption. Lawrence Goulder [10] calls this the "tax-interaction effect." And as Ian Parry [19] shows, so long as the output of polluting industries exhibits a (roughly) average degree of substitution for leisure, this effect will operate to increase the excess burden associated with the undersupply of work effort.

   Note that although the induced change in work effort (employment) may be small, the incremental distortion in the labor market can be quite large because the welfare loss per unit of employment at the margin is large reflecting the large difference between the gross and net wage.(4) In terms of our usual...