Enciclopédia da Energia Natural   CPMA.COMUNIDADES.NET
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Enciclopédia da Energia Natural CPMA.COMUNIDADES.NET

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revenues required by government, then revenue recy-
cling would completely eliminate the need for any distortion-
ary revenue taxes, so there would be no distortions at all in the
economy even though public goods were being provided by
government. If, however, the revenues from the environmental
tax were simply returned lump sum to the economy, then
distortionary revenue-raising taxes would be necessary to
raise revenue for government provision of public goods, and
welfare would be lowered as a result of the distortions and
resulting excess burden of the tax system. Both alternatives can
achieve a desired level of reduced pollution, but only with
revenue recycling would the distortions from revenue-raising
taxation be eliminated.
Most of the debate surrounding the validity of the double
dividend hypothesis, however, has hinged largely on the eval-
uation of the strong form. Indeed, there is a general agreement
that, under specific circumstances (involving relatively inelastic
demand for environmentally harmful goods), the optimal en-
vironmental tax with revenue recycling \u2018could\u2019 be higher than
the first-best Pigouvian rate. However, the pivotal debate has
centered on models that are \u2018neutral,\u2019 in the sense that the
demands for environmentally benign (clean) and environ-
mentally harmful (dirty) goods are assumed to be similar. As
such, findings for these models should hold for typical or
average situations.
Encyclopedia of Energy, Natural Resource and Environmental Economics http://dx.doi.org/10.1016/B978-0-12-375067-9.00073-5 37
The Tax Interaction Effect
In 1994, the validity of the double dividend hypothesis was
challenged in a set of theoretical papers that appeared to show
that, despite the presence of a positive revenue-recycling effect,
the optimal environmental tax would actually be \u2018lower\u2019 than
the Pigouvian rate when revenue-raising taxes are present.
These results caught many observers and even some of the
authors by surprise because they seemed logically incongruous:
they are at odds with the intuitive reasoning that the addition
of a revenue-recycling effect would increase the benefits of
green tax reform allowing the optimal environmental tax to
rise above the first-best Pigouvian rate. Authors including Lans
Bovenberg and Larry Goulder argued that their results were due
to the presence of a previously unknown distortionary cost,
which they dubbed the tax interaction (TI) effect. This effect,
they argued, was negative and large enough that it would
generally offset the positive revenue-recycling effect, resulting
in a net welfare change lower than expected from revenue-
neutral green tax reform and as a result weakening the justifi-
cation for environmental policy. Indeed, the TI research con-
cluded that government\u2019s goal of providing public goods
funded with tax revenue was in conflict with the goal of pro-
tecting the environment.
Although the central underlying question has been whether
the welfare gains from environmental taxation in the second-
best world are larger or smaller than in the first-best setting, in
the TI literature, this central question was framed indirectly by
asking whether the second-best optimal environmental tax is
higher or lower than the first-best Pigouvian rate, and then, this
indirect question was tested even more indirectly by relying on
a particular definition of marginal social damage (MSD) as a
proxy for the Pigouvian rate. The unstated presumption here is
that the value of MSD does not change when moving from the
first-best to the second-best setting, so that if the optimal
pollution tax appears higher (or lower) than MSD in the
second-best setting, then this means that the tax has increased
(or decreased).
Interpreting the Tax Interaction Findings
With the advantage of hindsight, three factors can be seen to
have contributed to overly negative and misleading interpreta-
tions in the TI literature: the use of an unreliable benchmark,
an algebraic error, and a failure to recognize compounding or
double taxation. As a result, the conclusion that a large, previ-
ously unnoticed distortionary TI effect existed has been shown
to be due to misleading evidence.
The first factor arose because of the highly indirect way the
TI literature tested whether the welfare changes from environ-
mental taxation in the second-best setting were larger or smal-
ler than in the first-best setting. The initial logic was sound and
goes something like this: in the first-best setting, as the authors
introduce a tax on pollution, the benefits (from internalizing
the externality) outweigh the costs (the distorting effects of tax
on consumer choice) over some range. At the optimum, when
the tax equals MSD, the marginal benefits are exactly equal to
the marginal costs, and no further increase in the pollution tax
can be justified on efficiency grounds. If, however, in the
second-best setting, there is an additional benefit from revenue
recycling (using the revenues to finance reductions in preexist-
ing taxes), then the benefits from introducing and raising the
environmental tax will be larger than in the first-best setting.
This means that the point where the marginal benefits are just
equal to the marginal costs should occur at a higher environ-
mental tax than in the first-best case, a tax level above the first-
best Pigouvian rate.
Rather than carrying out this test, however, the TI literature
made the test even more indirectly. Instead of comparing
the value of the second-best optimal environmental tax with
the value of the first-best optimal environmental tax (for ins-
tance dollars per gallon), it was compared to MSD defined in
algebraic terms rather than its numerical value at the first-best
optimum. The TI approach then sought to test whether the
second-best optimal environmental tax was higher or lower
than MSD. William Jaeger has shown that because MSD will
vary between the first-best and the second-best setting, it is not
a reliable benchmark or standard against which to compare the
level of the environmental tax. Moreover, the correct definition
of MSD is ambiguous, with three potentially valid alternatives.
The numerator of MSD is the marginal social disutility from
environmental damage, and this can be assumed to be con-
stant for simplicity. The denominator of MSD is the marginal
value of a unit of income, and its value depends on the level of
taxation. As a result, the test employed in the TI literature is not
reliable because it implicitly assumes that MSD is a stable
benchmark. Indeed, the TI literature also defines MSD in
terms of private marginal utility of income, although the social
marginal utility of income or the marginal value of public
funds could also be used, and these metrics diverge from the
private marginal utility of income in different ways in a second-
best setting (they all have the same value at the first-best
The second factor reinforcing the misleading conclusions
involves a straightforward algebraic error. Several authors
looked at Agnar Sandmo\u2019s seminal optimal tax results and
compared his equation for the optimal tax on dirty goods to
the equation for the optimal tax on a clean good. They noticed
that the two algebraic expressions were similar, differing only
by a separate term added to the expression for the tax on the
dirty good. It was thought that this second term was equal to
the environmental tax differential and that, by inspection, one
could see that this term declined as taxes increased in the
second-best setting \u2013 meaning that the environmental tax dif-
ferential got smaller. This second term, however, was not sim-
ply an additive