Environmental Taxes and the Double-Dividend Hypothesis: Did You Really Expect Something for Nothing

Chicago-Kent Law Review Volume 73 Issue 1 Symposium on Second-Best Theory and Law & Economics Article 6 December 1997 Environmental Taxes and the Double-Dividend Hypothesis: Did You Really Expect Something for Nothing Don Fullerton Gilbert E. Metcalf Follow this and additional works at: https://scholarship.kentlaw.iit.edu/cklawreview Part of the Law Commons Recommended Citation Don Fullerton & Gilbert E. Metcalf, Environmental Taxes and the Double-Dividend Hypothesis: Did You Really Expect Something for Nothing, 73 Chi.-Kent L. Rev. 221 (1998). Available at: https://scholarship.kentlaw.iit.edu/cklawreview/vol73/iss1/6 This Article is brought to you for free and open access by Scholarly Commons @ IIT Chicago-Kent College of Law. It has been accepted for inclusion in Chicago-Kent Law Review by an authorized editor of Scholarly Commons @ IIT Chicago-Kent College of Law. For more information, please contact . ENVIRONMENTAL TAXES AND THE DOUBLE-DIVIDEND HYPOTHESIS: DID YOU REALLY EXPECT SOMETHING FOR NOTHING?* DON FULLERTON** AND GILBERT E. METCALF*** INTRODUCTION Generally speaking, the "double-dividend hypothesis" suggests that increased taxes on polluting activities can provide two kinds of benefits. The first dividend is an improvement in the environment, and the second dividend is an improvement in economic efficiency from the use of environmental tax revenues to reduce other taxes such as income taxes that distort labor supply and saving decisions. These income tax distortions reduce the efficiency of the market economy, as estimates suggest that an additional dollar of revenue from the income tax imposes a burden on the private sector of about $1.35. The 35-cent difference is an "excess burden." In contrast, a tax on pollution can increase the efficiency of the private sector by making the producer face the full social costs of each polluting activity. Thus, the second dividend is a reduction in excess burden. To many, this proposition seems obvious. The policy debate has focused on specific pollutants that could readily be taxed, and specific taxes with high excess burden that could readily be reduced. Yet the academic debate has focused on the general validity of such a proposition. As described below, several important papers have shown that the environmental tax has its own distorting effects on labor supply and therefore can have the same excess burden as a tax on labor income. Thus, the double-dividend hypothesis is said to fail. * We are grateful for helpful comments and suggestions from Charles Ballard, Larry Goulder, Ian Parry, Kerry Smith, and J. Hoult Verkerke. The first author is grateful for financial support from a grant of the Environmental Protection Agency (EPA R824740-01-0), and the second author is grateful for financial support from a grant of the National Science Foundation ("NSF") to the National Bureau of Economic Research ("NBER") (NSF SBR-9514989). This paper is part of NBER's research program in Public Economics. Any opinions expressed are those of the authors and not those of the EPA, the NSF, or the NBER. ** Addison Baker Duncan Centennial Professor of Economics at the University of Texas, and a Research Associate with the NBER in Cambridge, Mass. From 1985 to 1987, he served as Deputy Assistant Secretary of the U.S. Treasury for Tax Analysis. *** Associate Professor of Economics at Tufts University, and a Research Associate with the NBER in Cambridge, Mass. Professor Metcalf's areas of research interest include tax policy, energy, and environmental economics. CHICAGO-KENT LAW REVIEW [Vol. 73:221 In this paper, we make four main points. First, the validity of the double-dividend hypothesis cannot logically be settled as a general matter. Clearly, under some conditions, a particular reform might be able to improve the environment and improve the tax system by reducing some particularly egregious existing tax. Equally clear is that some other misguided reforms would not. Each proposal must be evaluated individually. The important point is that this evaluation must fully specify the policies already in place as well as the reform under consideration. If this polluting activity is already taxed at a rate higher than the "optimal" rate, taking all considerations into account, then any suggested increase is not warranted. Even if it is taxed at a low rate, or not at all, the polluting activity might already be subject to other regulatory restrictions. Existing policies are crucial to understanding the benefits of any proposed reform. Moreover, the reform itself needs to be fully specified: Is this tax added on top of existing regulatory restrictions, or does it replace those restrictions? And how will the revenue be used? In this regard, an important contribution of the double-dividend debate is that the proposal to add an environmental tax is only half of a proposal, because the reform must also specify whether the revenue goes to deficit reduction, a specific spending program, or a specific tax reduction. Therefore, when we review some of the early and recent literature pertaining to the double-dividend hypothesis, we organize the discussion around two questions: What are the existing policies in place before the reform? And what exactly is the reform? Some of the papers do not address both of these questions, which leaves the double-dividend hypothesis inadequately specified. Then, without a well-articulated proposition, they proceed to argue its validity. Strictly speaking, the second dividend from an environmental tax reform is a reduction in excess burden from the entire tax system. As we show below, however, much of the literature has emphasized the importance of raising revenue in order to obtain this second dividend. Our second main point is that this focus on revenue is misplaced. A well-designed reform may generate environmental benefits, and it may reduce other existing distortions, but those outcomes are entirely unrelated to whether it raises revenue. We describe a non-revenueraising type of command-and-control regulation that has identical economic effects to the combination of an environmental tax increase and income tax reduction. We also describe a revenue-losing environmental subsidy (financed by an increase in the income tax) that has identical economic effects to a revenue-raising environmental tax (with 19981 DOUBLE-DIVIDEND HYPOTHESIS revenue used to reduce the income tax). If designed to affect behavior in the same way, all three have identical economic effects. The choice among these three policies then depends on considerations other than revenue, such as which policy is easier to administer, easier to enforce, or easier to enact. To make clear that revenue-raising cannot be the key to economic benefits, consider how the revenue is generated. That money must come from somewhere and impose costs on somebody. It is not free money. The impact of the reform depends on the extent to which polluting activit (...truncated)