From Shadow to Green: Linking Environmental Fiscal Reforms and the Informal Economy

In the past few decades many papers have analysed in some depth different environmental tax reforms and the double dividend hypothesis, i.e. the possibility of improving not only the environment but also the economy through the reduction of distortions in the tax system. Recently, more stress has been placed on testing empirically what effects a reduction in labour taxes may have on unemployment when accompanied by a carbon or other environmental tax. However, such studies have not modelled the effects of the presence of a shadow economy, even though informal markets account for a significant and growing part of GDP in many developed economies. This paper analyses this link using an Applied General Equilibrium model for the case of Spain, which has one of the highest unemployment rates in the world and one of the biggest informal economies of any wealthy country. We conclude that our analysis strengthens the case for an environmental tax reform in Spain if revenues from a CO2 tax are recycled via a labour tax reduction.