Economic Impacts 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).

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 (CO₂), 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. The simplest analytical models suggest that the answer is no.  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” 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 green tax reform makes it easier to understand the requirements for obtaining the second dividend.

The first component is the “primary cost” of the environmental tax, that is the direct cost to the regulated sector associated with changes in production methods or installation of pollution-abatement equipment required to reduce pollution.

The second component, which emerges in a general equilibrium analysis, is the revenue-recycling effect. As mentioned earlier, this component serves to lower the costs of the reform.

The third component is an additional general equilibrium impact called the “tax-interaction effect,” which can be explained as follows: to the extent that environmental taxes raise producers’ costs, they imply higher prices of commodities. This effectively reduces the real returns to factors — a given nominal wage payment or given nominal distribution of profits has less purchasing power. When there are pre-existing taxes on these factors, the environmental tax functions like an increase in factor taxes, compounding the distortions in factor markets from prior taxes. This adverse impact on factor markets is the tax-interaction effect.

The double dividend arises if three conditions hold: 1) the initial tax system is inefficient along some nonenvironmental dimension (that is, it fails to be second-best optimal even when environmental quality considerations are ignored); 2) the revenue-neutral environmental tax reduces this inefficiency, and; 3) the efficiency improvement along this dimension more than compensates for the inherent efficiency disadvantage of the environmental tax.

Prior Taxes and the Choice of Instrument for Environmental Regulation

General equilibrium tax interactions are also relevant to the cost impacts of other environmental policy instruments. For example, they fundamentally affect the costs of tradeable emissions permits, and they indicate that a great deal is at stake in choosing whether to freely allocate or auction these permits.

Moreover, pre-existing taxes differentially affect policy costs, altering the rankings of policies. The cost impact of pre-existing taxes is particularly large for (nonauctioned) emissions permits, potentially as much as several hundred percent. This has important policy implications. Economists have long argued that tradeable emissions permits and emissions taxes are more cost effective than performance standards, technology mandates, and other traditional forms of regulation.Our results suggest that in the context of NOx regulation, tradeable emissions permits will not yield cost savings over performance standards or technology mandates unless the permits are auctioned and the revenues used to cut other taxes.

Distributional Considerations and the Costs of Making Environmental Regulations More Attractive

The political resistance to environmental regulations may depend as much on the distribution of regulatory costs as on their aggregate level. Potential distributional impacts partly explain why a number of cost-effective policies for reducing emissions of CO₂ have failed to get off the ground politically. In particular, a revenue-neutral carbon tax would impose significant cost burdens on major energy industries. These industries are highly mobilized politically and can generate stiff opposition to policies that reduce their profits significantly.

Some policies avoid placing such large burdens on the energy industries. For example, a system of tradeable permits in which some of the permits are given out free. This is less costly to the regulated firms because it does not charge firms for every unit of fossil fuel (or carbon) introduced to the economy. But, as suggested earlier, the free provision of permits can imply much higher economy-wide costs of achieving given reductions in fossil fuel supply. Thus, there is an apparent trade-off between promoting efficiency and avoiding “undesirable” impacts on key industries (and enhancing political feasibility).

By designing policies that enable firms to retain even a small fraction of the potential revenues, the government can protect firm profits. Government revenue has an efficiency value because it can be used to finance cuts in pre-existing distortionary taxes. Because these abatement policies forgo little of this potential revenue, they involve only a small sacrifice of efficiency. It is also possible to insulate profits of other downstream industries that might otherwise experience significant profit losses. The revenue sacrifice (and thus the relative loss of efficiency) remains fairly small, even when petroleum refiners and electric utilities are brought into the “insulation net.”

* by Lawrence H. Goulder