Are Green Taxes a Good Way to Help Solve State Budget Deficits?

Sustainability 2012, 4, 1329-1353; doi:10.3390/su4061329 OPEN ACCESS sustainability ISSN 2071-1050 www.mdpi.com/journal/sustainability Article Are Green Taxes a Good Way to Help Solve State Budget Deficits? Rong Zhou and Kathleen Segerson * Department of Economics, University of Connecticut, Box U-63, Storrs, CT 06269, USA; E-Mail: * Author to whom correspondence should be addressed; E-Mail: ; Tel.: +1-860-486-4567; Fax: +1-860-486-4463. Received: 8 May 2012; in revised form: 31 May 2012 / Accepted: 7 June 2012 / Published: 18 June 2012 Abstract: States are increasingly turning to environmental taxes as a means of raising revenue. These taxes are often thought to generate a double dividend: an environmental dividend stemming from the environmental improvement, and an economic dividend resulting from use of the revenue from environmental taxes to reduce other distortionary taxes (e.g., income or sales taxes). We review the economic literature on the double-dividend hypothesis, and show explicitly that the conditions under which the second dividend exists are less likely to hold when the amount of revenue that would be raised by an optimal environmental tax is small relative to the tax revenue from other taxes. We then present estimates of the potential revenue that could be raised from two environmental taxes in Connecticut. The results suggest that, because of their small tax base, environmental taxes are likely to have limited potential to raise revenue to finance state government budget deficits and/or reduce other distortionary taxes. Overall, environmental taxes could still generate significant gains for society if they lead to significant improvements in environmental quality. However, without more evidence of the existence of a double dividend, states should not try to justify these taxes on the basis of raising revenue more efficiently. Keywords: environmental taxes; double dividend; revenue raising; budget deficits; tax base Sustainability 2012, 4 1330 1. Introduction Many states in the U.S. currently face significant budget deficits and are looking for ways to raise revenue to help close budget gaps. For example, the FY 2012 projected budget deficit for the State of Connecticut was $3.2 billion [1]. In an effort to reduce the projected deficit and ultimately balance its budget, the state recently raised existing tax rates and added some new taxes [2]. The primary source of additional revenue was increased income taxes and sales/use taxes. While income and sales taxes are the primary fiscal instruments used by states to raise revenue, during the past two decades or so, there has been an increasing interest in using environmental taxes as a source of revenue to help reduce budget deficits. Environmental taxes have long been advocated by economists as a means of internalizing pollution externalities, i.e., forcing private parties to pay for the environmental impacts of their decisions, thereby discouraging behavior that is harmful to the environment. While more common in Europe (e.g., Ekins [3], Sterner and Köhlin [4]), environmental taxes have not historically been used to address environmental concerns in the U.S.. However, concerns about budget deficits, at both the federal and state levels, have increased the interest in using environmental taxes for another reason, namely, to raise tax revenue. For example, Oates [5] argued that a national tax on sulfur and nitrogen oxide emissions could be considered as a revenue-raising tool to help reduce the federal budget deficit. More recently, when discussing the potential use of a carbon tax, William Nordhaus [6] states: “Simply put, there is no better fiscal instrument to employ at this time, in this country, and given the fiscal constraints faced by the U.S.”. Similar arguments have been made at the state level. For example, in 2011 Texas considered imposing a state gas guzzler tax to raise revenue and to help address its multibillion-dollar budget shortfall. Under this proposal, a $100 surcharge would be imposed on sales of all new cars (including light trucks and SUVs) not meeting federal fuel economy standards [7]. Similarly, while the initial purpose of Maryland’s “flush tax” was to raise revenue to fund restoration efforts for the Chesapeake Bay [8], lawmakers recently considered increasing the annual tax from $30 to $54 per household to help raise revenue to balance the state’s budget deficit [9]. These proposals raise the following question: what role could/should environmental taxes play as a source of revenue to help reduce government budget deficits? The answer to this question needs to address the two dimensions of environmental taxes noted above: (1) their ability to discourage polluting behavior, and (2) their ability to raise tax revenue. Regarding this second dimension, the question is whether environmental taxes are a “good” or a “better” way to raise tax revenue than other traditional sources, such as income or sales taxes. In other words, if the need to raise (additional) revenue is taken as a premise, the question is whether raising the required revenue using environmental taxes leads to a better outcome for society as a whole than raising that same amount of revenue using a different tax mix. There is a large literature within economics relating to the above question (see discussion below). It seeks to evaluate the argument that environmental taxes generate a “double dividend” by simultaneously internalizing pollution externalities, thereby improving environmental quality, and raising revenue, thereby allowing reductions in, for example, income and sales taxes, which are known to discourage productive activities. While the first dividend is strongly supported by the theoretical and empirical literature, the second dividend is more contentious. Sustainability 2012, 4 1331 The purpose of this paper is to draw on the double dividend literature to shed some light on whether states should seek to reduce budget deficits using environmental taxes. After reviewing the double dividend literature, we present a stylized economic model that provides an explicit formulation of the double dividend hypothesis and illustrates the critical role that the magnitude of the tax base plays in determining if it holds. The basic conclusion is that, although environmental taxes are efficient instruments for improving environmental quality, they are not necessarily a better way to raise revenue than other types of taxes (e.g., income tax and sales tax), due at least in part to their relatively small tax base. We then present an example from the State of Connecticut that estimates the tax revenue that might be raised from a state-level carbon tax or gas-guzzler tax and compare this with the revenue raised from the state’s income and sales taxes. This comparison highlights the relative magnitudes of the tax bases, and suggests that, because the environmental tax base is relatively small, environmental taxes ma (...truncated)