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Environmental Policy Making in a Second-Best Setting

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This paper uses analytically tractable and numerically solved general equilibrium models to examine the significance of pre-existing distortions in factor markets for revenue-neutral environmental tax reforms and for various policies involving pollution quotas and permits. Results indicate that pre-existing factor taxes generally raise the costs of these environmental policies. This reflects a tax-interaction effect: the lowering of real factor returns resulting from the higher output prices occasioned by environmental taxes and other regulations. The revenue-recycling effect - stemming from the use of environmental tax revenues to finance cuts in pre-existing factor taxes - helps reduce policy costs, but under plausible assumptions does not eliminate the costs of such policies: the double dividend does not materialize. Even if it does not produce a double dividend, the revenue-recycling effect is important for reducing policy costs. Policies that fail to exploit the revenue-recycling effect suffer significant disadvantages in terms of efficiency. Like environmental taxes, freely allocated (or grandfathered) pollution quotas or permits, for example, produce a costly tax-interaction effect, yet such quotas or permits do not enjoy the offsetting revenue-recycling effect. Auctioning the permits or quotas makes possible the revenue-recycling effect and allows given pollution-abatement targets to be achieved at lower cost. The failure to exploit the revenue-recycling effect can alter the sign of overall efficiency impact. Indeed, if marginal environmental benefits from pollution reductions are below a certain threshold value, then any level of pollution abatement through freely allocated quotas or permits is efficiency-reducing. The tax-interaction effect is relevant to government regulation outside the environmental area. To the extent that regulations on international trade or agricultural production raise output prices and thereby reduce real factor returns, these regulations exacerbate the factor-market distortions from pre-existing taxes and thus involve higher social costs than would be indicated by partial equilibrium analyses.

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  • Lawrence H. Goulder, 1998. "Environmental Policy Making in a Second-Best Setting," Journal of Applied Economics, Universidad del CEMA, vol. 1, pages 279-328, November.
  • Handle: RePEc:cem:jaecon:v:1:y:1998:n:2:p:279-328
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    2. Sobieralski, Joseph B., 2013. "The optimal aviation gasoline tax for U.S. general aviation," Transport Policy, Elsevier, vol. 29(C), pages 186-191.
    3. Walid Oueslati, 2013. "Short and Long-term Effects of Environmental Tax Reform," Working Papers 2013.09, Fondazione Eni Enrico Mattei.
    4. Jesse D. Jenkins & Valerie J. Karplus, 2016. "Carbon pricing under binding political constraints," WIDER Working Paper Series wp-2016-44, World Institute for Development Economic Research (UNU-WIDER).
    5. Ian W. H. Parry, 2003. "Fiscal Interactions and the Case for Carbon Taxes Over Grandfathered Carbon Permits," Oxford Review of Economic Policy, Oxford University Press, vol. 19(3), pages 385-399.
    6. Devarajan Shantayanan & Go Delfin S & Robinson Sherman & Thierfelder Karen, 2011. "Tax Policy to Reduce Carbon Emissions in a Distorted Economy: Illustrations from a South Africa CGE Model," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 11(1), pages 1-24, February.
    7. Macdonald, Kevin & Patrinos, Harry Anthony, 2021. "Education Quality, Green Technology, and the Economic Impact of Carbon Pricing," GLO Discussion Paper Series 955, Global Labor Organization (GLO).
    8. Ying, Zhang & Irland, LIoyd & Zhou, Xiaohong & Song, Yajie & Wen, Yali & Liu, Junchang & Song, Weimin & Qiu, Yang, 2010. "Plantation development: Economic analysis of forest management in Fujian Province, China," Forest Policy and Economics, Elsevier, vol. 12(3), pages 223-230, March.
    9. Goulder, Lawrence H., 2013. "Climate change policy's interactions with the tax system," Energy Economics, Elsevier, vol. 40(S1), pages 3-11.
    10. Macdonald, Kevin & Patrinos, Harry A., 2021. "Education Quality, Green Technology, and the Economic Impact of Carbon Pricing," IZA Discussion Papers 14792, Institute of Labor Economics (IZA).
    11. Jesse D. Jenkins & Valerie J. Karplus, 2016. "Carbon pricing under binding political constraints," WIDER Working Paper Series 044, World Institute for Development Economic Research (UNU-WIDER).
    12. Oueslati, Walid, 2014. "Environmental tax reform: Short-term versus long-term macroeconomic effects," Journal of Macroeconomics, Elsevier, vol. 40(C), pages 190-201.
    13. Östblom, Göran & Hammar, Henrik, 2007. "Outcomes of a Swedish Kilometre Tax. An analysis of Economic Effects and Effects on NOx Emissions," Working Papers 103, National Institute of Economic Research.
    14. Gonzalez, Fidel, 2012. "Distributional effects of carbon taxes: The case of Mexico," Energy Economics, Elsevier, vol. 34(6), pages 2102-2115.
    15. Devarajan, Shantayanan & Go, Delfin S. & Robinson, Sherman & Thierfelder, Karen, 2009. "Tax policy to reduce carbon emissions in south Africa," Policy Research Working Paper Series 4933, The World Bank.
    16. Ross McKitrick, 2017. "Emission Taxes and Damage Thresholds in the Presence of Pre-existing Regulations," Working Papers 1705, University of Guelph, Department of Economics and Finance.

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