ANALYSIS
The double dividend, second-best worlds, and real-world
environmental policy
James R. Kahn
a,b,*, Amy Farmer
aaDepartment of Economics,534Stokely Management Center,Uni6ersity of Tennessee,Knox6ille,TN37996-0550,USA bOak Ridge National Laboratory,MS6205Oak Ridge,TN37831-2008,USA
Received 26 May 1998; received in revised form 4 January 1999; accepted 6 January 1999
Abstract
The recent series of papers by Bovemberg, Goulder, Parry and others argue that the double dividend is unlikely to exist because of second-best problems. They argue that the imposition of environmental tax in an economy already distorted by income taxes will further distort the economy by reducing incentives to supply labor. Our paper argues that this is not likely to be the case because of the restrictive assumptions made by these models, and because of the role of the environment as a factor of production. © 1999 Elsevier Science B.V. All rights reserved.
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1. Introduction
In the early 1990s, a literature developed which suggested a source of additional benefits from environmental taxation.1 This literature
suggested that in addition to the benefits achieved by correcting the market failure associ-ated with pollution, there could be a second benefit associated with improving efficiency in the market for labor. These authors argued that
if the revenue obtained from environmental tax-ation were used to reduce taxtax-ation of labor, it would reduce the distortion in the labor market, thereby reducing the dead-weight loss associated with income taxes. The policy implication of the existence of this second effect is that the socially optimal externality tax is greater than that which completely internalizes the externality (and the optimal level of emissions is less than that which completely internalizes the external-ity).
This literature has become known as the ‘dou-ble dividend’ literature. The first benefit or divi-dend is generated by reducing the environmental
* Corresponding author. Tel.: +1-423-974-1699. E-mail address:jkahn@utk.edu (A. Farmer) 1See Pearce (1991), for example.
externality towards the optimal level and is often termed the Pigo6ian effect. The second dividend
from reducing distortion in the labor market has become known as the ‘revenue recycling effect’.2
A more recent set of articles3 argues that there
is no double dividend because in the second-best world where labor is already taxed, an environ-mental tax will increase the price of the polluting goods, thereby reducing the incentive to work and further distorting the labor market. This effect has become known as the tax interaction effect, and these articles suggest that the negative tax interac-tion effect will dominate the positive revenue recy-cling effect. If these effects have the relative magnitudes suggested by this second strand of the literature, the environmental policy implication is that the socially optimal externality tax should be less than that which completely internalizes the externality (and the target level of emissions should be greater than that which completely internalizes the externality.)
The economics profession, with few exceptions, seems to have seized upon the second set of articles and accepted the existence and dominance of the tax interaction effect. However, we strongly believe this conclusion to be an artifact of the structure of the models which have been used to examine the double dividend.
This paper examines the models which other authors such as Bovenberg and de Mooij (1994); Parry (1995) and Bovenberg and Goulder (1996) have used to examine the double dividend, and analyzes the behavioral assumptions underlying the models. We find that there are many factors which have been excluded from the analysis of the second strand of the double dividend literature which would serve to make the double dividend positive. Therefore, the existence of the double dividend must be regarded to be an empirical question, awaiting the test of future research.
2. Summary of existing models
Bovenberg and de Mooij (1994) study the tax interaction effect in a general equilibrium frame-work. In their model, consumers maximize utility subject to both a household budget constraint and a government budget constraint. Utility depends upon consumption of clean and dirty commodi-ties, leisure, environmental quality and
govern-ment spending. In order to perform this
optimization, they assume that public goods (gov-ernment spending and environmental quality) are weakly separable from private goods. Within the private goods sub-utility function, consumption goods aggregate into a composite commodity while leisure remains the other commodity. Given these specific assumptions, they show that house-holds supply labor based upon the after tax real wage.
Individual utility maximization yields both the labor supply (as a function of the real wage) and the demand for the dirty commodity. Due to the separability assumptions, labor supply does not directly depend upon the price of dirty goods or environmental quality. Expressions for the labor supply and the demand for the dirty commodity are then combined with the government budget constraint to determine the ultimate impact on labor supply. In so doing, Bovenberg and de Mooij (1994) find that labor supply falls, thus further distorting the labor market. This results from the fact that a rise in the tax on the dirty commodity will erode the tax base (by inducing consumers to switch to the clean commodity) and will therefore cause after tax real wages to fall. This ultimately diminishes the incentives to supply labor, and prevents the government from reducing the labor tax enough to compensate for the higher priced dirty commodity.
Note that the separability assumptions prevent an interaction between labor supply and either the provision of public goods or environmental qual-ity. In addition, leisure is a substitute for the composite consumption good. If these assump-tions are relaxed, the results described above may no longer hold.
2Note that the revenue recycling effect is usually based on the assumption of a revenue neutral substitution of pollution taxes for income taxes.
3. Substitutes and complements
Due to the separability assumptions, it is possi-ble to solve for the change in the labor supply as the tax on the dirty commodity rises independent of any changes in the provision of public goods, environmental quality or the price of the clean and dirty commodities. It is important to note that although these assumptions make the model tractable, they do contribute to the primary find-ings of these papers.
Consider first the possibility of interdependence between consumption and environmental quality. In this case it is not simply the after tax real wage that determines labor supply. In particular, an improvement in environmental quality may in-crease the demand for the dirty commodity thus diminishing the erosion of the base. Similarly, if improvement in environmental quality lessens the demand for the clean commodity (i.e. they are substitutes), the demand for the dirty commodity may not diminish much with an increase in the tax; thus, the erosion of the base would be dampened. On the other hand, leisure may be a complement to environmental quality; in this case labor supply may fall even further as a tax on the dirty com-modity alters consumption behavior.
Another possibility is that the demand for other public goods may change with environmental quality and the government budget constraint may not need to be held constant. For example, the demand for collectively provided public goods may fall as the quality of naturally provided public goods increases (beaches, forests, lakes, clean air days, etc.). Thus, relaxing the separability assump-tions would allow preferences for public goods (and therefore the government budget constraint) to be affected by environmental taxation.
Finally, consider the assumption that leisure is a substitute for the composite consumption com-modity. Suppose leisure is a complement to the dirty commodity; for example, suppose a family might prefer to take a driving vacation if gasoline prices are low. In this case, a rise in the tax may improve the incentives to supply labor. This rela-tionship is not possible given the assumption of substitutability between consumption goods and leisure.
Consequently, while the tax interaction effect may dominate the double dividend possibility, this finding is dependent upon the specific assumptions required for tractability of the model. Relaxation of these various assumptions could produce a wide range of possible outcomes.
In a follow-up paper, Bovenberg and Goulder (1996) extend this model to incorporate a tax on intermediate inputs. Similar methodology and as-sumptions are employed and the conclusions re-main unchanged. In his model, Parry (1995) considers a demand for leisure and a dirty com-modity. When these two goods are substitutes, a tax causes the price of the dirty commodity to rise, thus raising the demand for leisure. Consequently, consumption will fall as labor supply falls, and, under the structural assumptions of the model, total welfare falls since this effect dominates the revenue recycling possibility combined with the benefits from the reduction of the dirty good. Parry (1995) relaxes the assumption of substi-tutability between these two goods, and in so doing, he finds that when the dirty commodity is a weak substitute for leisure, the previous result may fail. This is further evidence supporting the point that the findings from these models are dependent upon particular functional specifica-tions. Since the model does not utilize a general equilibrium approach, Parry’s (Parry, 1995) model also does not capture possible interactions between leisure, public goods, environmental quality and the demand for private consumption.
4. The environment as a factor of production
The most important omitted economic relation-ship is the role of environmental quality as a factor of production. If environmental quality is a factor of production, then an increase in environ-mental quality will reduce the amount of labor, capital, energy and other factors of production required to produce a given level of output. In other words, if environmental quality is a factor of production, then a pollution tax will lower the cost of producing goods, partially, fully or more than fully offsetting the tax interaction effect.
Although the environmental economics litera-ture has recognized the importance of the envi-ronment as an input to the production process for over three decades4, the importance of the
envi-ronment as an input has been less recognized by the overall literature in economics. The produc-tion funcproduc-tions of BMPG, following this more traditional vein of economic theory, do not con-sider the environment to be a factor of produc-tion. However, this is an erroneous assumption as the environment contributes to the economic pro-cess in numerous ways, and reduced environmen-tal quality inhibits production in numerous fashions.
This assertion of a positive productivity of the environment may seem counter-intuitive to the non-environmental economist, who is accustomed to viewing the environment and the economy as mutually opposed. The conventional economic viewpoint expresses a trade-off between the econ-omy and the environment, with better environ-mental quality only coming at the expense of reduced economic performance. To suggest other-wise is viewed as a fundamental violation of the economic law that there is no such thing as a free lunch.
This viewpoint has been expressed in many studies concerning the impact of environmental regulation on the economy.5Analyses of the
inter-action between the economy and the environment have been limited to looking at how the devotion of resources to abatement of emissions lowers GDP. Espinosa and Smith (1995) point out the inconsistency of this genre of economic models which associate costs with emissions reductions, but have no corresponding benefits.
These early models found the impact of envi-ronmental regulation to be a 1 – 3% loss in GDP. However, the role of the environment as a factor of production has been completely ignored in these studies, until a recent study by Gillis et al. (1996). Gillis and his co-authors showed that by simply including the positive economic impacts of air quality improvements on human health, the outcomes of these competitive general equilibrium models flip. Rather than suggesting a decline in economic output, the environmental regulations were shown to lead to a 2% increase in GDP. There would be additional non-market benefits associated with improved health.
The human health impact sheds considerable insight into the potential existence of a positive double dividend. In addition to the direct effects on utility from improved health (non-market benefits which do not directly affect GDP), im-proved health directly impacts GDP by increasing the marginal productivity of labor. If the marginal product of labor increases as a result of better environmental quality, then increasing environ-mental quality will increase the incentives to sup-ply labor.
Obviously, the human health argument is an important component of the role of environmen-tal quality as a factor of production, but many other examples can be cited. For example, many studies have been conducted which look at the impact of air pollution on both agricultural and silvicultural productivity. The National Acid Pre-cipitation Assessment Program6 looked at a
vari-ety of studies in the literature and concluded that a 10% reduction (from the late 1980s level) in just one type of air pollution (precursors to tropo-spheric ozone) would increase net economic benefits from agriculture by 0.789 billion 1989
4Some of the early work in this area includes the input/ out-put modeling of Cumberland (1966), Daly (1969) and the general equilibrium modeling of Ayres and Kneese (1969).
dollars. A corresponding reduction of 25% in tropospheric ozone levels would increase net eco-nomic benefits derived from agriculture by 1.7 billion dollars. Corresponding measurements for southern pine forests were 40 – 100 million dol-lars.7 Similarly, Kahn and Kemp (1985), Smith
and Desvousges (1985), Silvander and Drake (1991), Barbier and Strand (in press) and many others have measured the importance of water quality to commercial and recreational fishing activity.
In addition to the human health, agriculture, silviculture and the fisheries examples, it is not difficult to cite many other examples from day-to-day life. A small subset of examples of the impor-tance of environmental quality to the production process include the impacts of:
1. Air pollution on materials and paint.
2. Water pollution on beer or soft drink manu-facturers (and virtually every other production activity that requires clean water as an input). 3. Mercury and other heavy metals on the
intelli-gence and learning abilities of children. 4. Air and water pollution on the recreational
and tourism industries.
5. Air pollution on a micro-chip producer’s need for a super-clean production facility.
6. Impaired visibility (from air pollution) on transportation.
7. Air pollution emergencies on the total econ-omy of Southern California.
8. Global warming on almost every sector of the economy.
In all these cases, resources must be expended by producers and consumers to counteract the nega-tive impact of the pollution that is generated by others.
The implications of these examples (particularly the finding by Gillis et al. (1996) for the double dividend argument are straightforward. Since the environment is a demonstratively (both from a conceptual viewpoint and the empirical evidence provided by Gillis et al. (1996), NAPAP, and all the fisheries examples) important input to
produc-tive processes, an increase in the level of environ-mental quality will lower the prices of goods in general, providing a positive incentive to provide labor which will reduce the general distortion in the labor market. In their general equilibrium modeling of the US economy, Gillis et al. (1996) find that the health effect alone dominates the abatement capital effect. This suggests that the impact of all environmental quality effects on the prices of all goods is likely to dominate the impact of the increase in abatement costs on the price of polluting goods.
5. The environmental tax and the nature of responses
The Bovenberg type models construct their en-vironmental tax as a tax on the output of the polluting good. Moreover, they assume a fixed relationship between the output level of the pol-luting good and the emissions of pollution. While this structure is very convenient in terms of sim-plifying the analytics of the model, it is extremely limiting in terms of modeling the firms’ ability to respond to a tax.
As discussed in Baumol and Oates (1988) and virtually every other discussion of the theory of environmental policy, the optimal tax is an exter-nality tax, levied on each unit of the exterexter-nality, rather than a tax on the output level of the produced good or a tax on purchased inputs. This tax on the externality itself allows a range of responses by the polluter to lessen both the exter-nality and the associated tax payment. For exam-ple, a polluter can respond to the tax by installing end-of-the-pipe technology to capture emissions, switching to cleaner inputs, modifying productive processes to create less waste, or reducing output. A tax on the output of the polluting good only encourages the reduction of output and gives no incentive to engage in any of the other options, which may be less costly.
How important is this omission? This question is difficult to answer because of the lack of experi-ence with true externality taxes. In terms of the incentives created for polluters, our closest experi-ence to a true externalities tax is not actually a
tax, but the sulfur dioxide trading system imple-mented according to the provisions of the 1990 Clean Air Act Amendment. The market price of these permits is significantly less than thea priori
predictions because the cost of reducing sulfur dioxide emissions was significantly lower than the predicted. This lower than predicted cost was primarily due to the type of responses chosen by polluters. Rather than relying on increased capital expenditure and smokestack removal of emis-sions, electric utilities switched from higher sulfur (but cheaper) eastern coal to lower sulfur (but more expensive) western coal. This fuel switching was accelerated by a reduction in railroad trans-portation rates, which may have been a regulatory response to economies associated with expanding the scale of western coal shipments.
While this evidence is anecdotal, it does illus-trate the importance of a full range of responses to a pollution tax, the existence of which reduces the cost of reducing the pollution tax burden. Both economic theory and this evidence suggest that a per-unit-of-output pollution tax must gen-erate a greater price increase than a per unit pollution tax. The BMPG choice of tax instru-ment therefore maximizes the magnitude of the tax interaction effect.
A more recent paper by Goulder et al. (1998) drops the construct of an output tax, and com-pares an emissions tax to non-marketable emis-sions quotas, marketable emisemis-sions quotas, fuel taxes, performance standards and least-cost tech-nology mandates. They show that in the context of their models that the emissions tax outperforms everything but the marketable quotas (to which it is equivalent) in a first-best world, and out-per-forms all other policies in a second-best world with distortion in the labor market. In their mod-eling efforts and numerical simulations, they still find that the tax interaction effect dominates the revenue recycling effect. Of course, they do not address the other shortcomings of the models such as the separability assumption and the lack of consideration of the environment as a factor of production. These shortcomings must be ad-dressed before one can truly compare the tax interaction effect and the revenue recycling effect. Furthermore, even though they improve the
model in the sense that they are now utilizing an emissions tax instead of an output tax, their model does not really allow a full range of re-sponses to the taxes. All abatement activity in their models is seen as ‘end of pipe’ abatement. End of pipe abatement represents a cost at-tributable solely to abatement and does not con-tribute to the production of output; therefore end of pipe treatment is also the most costly type of abatement. For example, if an electric utility was forced to pay a tax based on its emissions of sulfur dioxide, it could respond by (among other options) installing an electrostatic precipitator to remove the sulfur from its flue gases or by in-stalling a boiler/steam turbine system that pro-duced more electricity per unit of coal, thus lowering both the emissions per unit of electricity and the variable costs of producing electricity. Although most studies of the cost of abatement have not sought to incorporate this quasi-produc-tive abatement capital, Collins (1996) found that considering quasi-productive capital has impor-tant implications for productivity. He found that contrary to previous studies which did not con-sider quasi-productive capital, increased strin-gency of environmental regulations often did not lead to losses in GDP.
6. Conclusion
Although it is difficult to formally test the hypothesis of the potential existence of a double dividend, the policy implications of the potential existence are too important to rely on the results of a set of stylized models, however elegant they may be. This is particularly true as we consider the merits of limiting greenhouse gas emissions, and further limiting the emissions of sulfur diox-ide, nitrogen oxides, volatile organic compounds and to extending environmental taxes to non-point pollution sources, open-access resources, and degrading land uses. Further research is needed to resolve this issue, but in the meantime we should be careful not to limit the debate on policy options as the result of the outcomes of these few stylized models.
Acknowledgements
The authors would like to thank Judith Mc-Donald, Talbot Page, Herman Daly and Jeffery Collins for helpful comments.
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