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Environmental Policy Making in a Second-Best Setting

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  • Lawrence H. Goulder

Abstract

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.

Suggested Citation

  • Lawrence H. Goulder, 1998. "Environmental Policy Making in a Second-Best Setting," Journal of Applied Economics, Taylor & Francis Journals, vol. 1(2), pages 279-328, November.
  • Handle: RePEc:taf:recsxx:v:1:y:1998:i:2:p:279-328
    DOI: 10.1080/15140326.1998.12040525
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    Cited by:

    1. Jenkins, Jesse D., 2014. "Political economy constraints on carbon pricing policies: What are the implications for economic efficiency, environmental efficacy, and climate policy design?," Energy Policy, Elsevier, vol. 69(C), pages 467-477.
    2. 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.
    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. 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).
    6. Daniel Jaqua & Daniel Schaffa, 2022. "The case for subsidizing harm: constrained and costly Pigouvian taxation with multiple externalities," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 29(2), pages 408-442, April.
    7. Linda Ferguson & Peter Mcgregor & J. Kim Swales & Karen Turner & Ya Ping Yin, 2005. "Incorporating sustainability indicators into a computable general equilibrium model of the scottish economy," Economic Systems Research, Taylor & Francis Journals, vol. 17(2), pages 103-140.
    8. 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 and Oxford Review of Economic Policy Limited, vol. 19(3), pages 385-399.
    9. 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.
    10. 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).
    11. Homma, Takashi & Akimoto, Keigo & Tomoda, Toshimasa, 2009. "Evaluation of CO2 emissions based on the consumption-based measurement under CO2 reduction scenarios of different reduction levels," Conference papers 331871, Purdue University, Center for Global Trade Analysis, Global Trade Analysis Project.
    12. Gonzalez, Fidel, 2012. "Distributional effects of carbon taxes: The case of Mexico," Energy Economics, Elsevier, vol. 34(6), pages 2102-2115.
    13. Sobieralski, Joseph B., 2013. "The optimal aviation gasoline tax for U.S. general aviation," Transport Policy, Elsevier, vol. 29(C), pages 186-191.
    14. Lori Bennear & Robert Stavins, 2007. "Second-best theory and the use of multiple policy instruments," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 37(1), pages 111-129, May.
    15. Lynn Mainwaring & Richard Jones & David Blackaby, 2006. "Devolution, sustainability and GDP convergence: Is the Welsh agenda achievable?," Regional Studies, Taylor & Francis Journals, vol. 40(6), pages 679-689.
    16. Goulder, Lawrence H., 2013. "Climate change policy's interactions with the tax system," Energy Economics, Elsevier, vol. 40(S1), pages 3-11.
    17. Oueslati, Walid, 2014. "Environmental tax reform: Short-term versus long-term macroeconomic effects," Journal of Macroeconomics, Elsevier, vol. 40(C), pages 190-201.
    18. 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.
    19. Xinming Du, 2023. "Symptom or Culprit? Social Media, Air Pollution, and Violence," CESifo Working Paper Series 10296, CESifo.
    20. 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.

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