Tax deductions, environmental policy, and the"double dividend"hypothesis

The authors find that incorporating tax-favored consumption in models of environmental tax swaps may overturn key results from earlier studies. In particular, a revenue-neutral pollution tax (or auctioned permits) can produce a substantial"double dividend"by reducing both pollution and the costs of the tax system. The second dividend arises because the welfare gain from using environmental tax revenues to cut labor taxes is much larger when labor taxes also distort the choice among consumption goods. Indeed, (ignoring environmental benefits), the overall costs of a revenue-neutral pollution tax are negative in the benchmark simulations, at leastfor pollution reductions up to 17 percent, and possibly up to 42 percent. In addition, the authors show that the presence of tax-favored consumption may drastically increase the efficiency gain from using (revenue-neutral) emissions taxes (or auctioned emissions permits) rather than grand-fathered emissions permits.