Question

What is the concept of a “double dividend” associated with a tax on environmental emissions? Do you think that a double dividend is an outcome that is achievable? How would you determine if a double dividend results from an environmental tax?

Answer 1

It refers to the notion that environmental taxes can both reduce pollution (the first dividend) and reduce the overall economic costs associated with the tax system by using the revenue generated to displace other more distortionary taxes that slow economic growth at the same time (the second dividend).

Many concerns about competitiveness could be allayed if ETRs would be
implemented and harmonized across EU Member States. A major
shortcoming of ETRs is the unpredictability of the direction of tax
reforms in the long run. The most important effect of an ETR is
behavioural change, which can be achieved if reliable, long-term trends in
the tax structure are communicated to the taxpayer.

Challenges in ETRs:

Resource allocation and distribution
The special provisions and exemptions under ETRs highlight some important challenges
in resource allocation and distribution. First, quantity taxes (or ad valorem taxes) on
energy are regressive and place a greater burden on low-income households. ETRs should
include mechanisms to mitigate such effects, especially if they are implemented on larger
scales in the future. One possible improvement to ETR is the inclusion of personal energy
allowances within the tax structure (see also von Weizsaecker et al. (2010)). Under these
allowances, a certain amount of energy per household is exempt from tax, but energy used
beyond the threshold is taxed, possibly with a progressive rate. The threshold amount of
energy and the tax rate can also be crafted to the personal characteristics of households, ike family size or income. Such a mechanism would improve distributional justice within
an ETR scheme while creating an incentive to reduce energy consumption.
Second, it is striking that all countries created special provisions for certain industries that
were usually energy-intensive, while no exceptions exist for households. However, the
largest potential for CO2 emissions reduction is in the production sector and mainly in
those industries that have been granted special tax provisions. Indeed, approximately
80 per cent of the CO2 emissions of industrialized economies are emitted through
production activities and only about 20 per cent result from direct household
consumption (heat, petrol etc.). 8 It is important to note that special provisions for
industries allow them to impose externalities on the public, even if the public is
represented by a future generation. The provisions are then nothing more than a hidden
subsidy and result in an inefficient allocation.

Determining DD

The first dividend is an increase in environmental quality

CO2 emissions constitute an externality. These emissions result in damage to the

environment, which translates into reduced output, reduced profits, as well as other utility losses. The free market process therefore arrives at an inefficient allocation, as it does with

all externalities. A Pigou tax is one policy tool that can correct the externality and improve

welfare and efficiency (see for example Nordhaus (2008); Goulder (1995a)).

Dealing with this kind of externality (CO2 emissions) is very complex, given its dynamic

nature: First, polluters have been polluting in the present and in the past, while most of

the damages will occur in the future. Second, the aggrieved parties are to a large extent

unborn future generations. Third, the magnitude of future damages is highly uncertain,

since the complexity of the climate system is not fully understood. In other words, the

cost of the externality is difficult to quantify. Finally, the greenhouse effect is a global

problem and polluters and aggrieved parties are dispersed across national borders and

world regions.

The efficiency gains of the first dividend, an improvement of the environment through a

reduction of global GHG emissions, already result in increased output and increased

employment on a worldwide scale. However, due to the complexities mentioned, it is not

clear which regions of the world can expect output and employment gains, and whether

these gains occur now or in the future.

From a political point of view, internalizing the externality of CO2 emissions is extremely

difficult. Yet, when considering global population and global GDP, the current allocation

(i.e. the one with unregulated CO2 emissions) is inefficient and removing the externality

leads to a Pareto improvement (see Foley (2007); Rezai et al. (2009)). This means that it is

possible to shift world GDP growth to a path where no one is worse off and at least some

people are better off. Internalization of the external effect produces the first dividend.

From here on, this first dividend is referred to as “environmental benefits”, even though it

is emphasized that these benefits can very well be translated into tangible economic terms

like higher future GDP, higher profits, higher consumption or higher employment.

The problem with this first dividend, which is alone justification for environmental taxes

or other corrective instruments, is that the magnitude of the benefits is uncertain and may

lie far in the future (see Goulder (1995b)). In fact, implementation of the tax imposes

costs on those who currently over-emit CO2 in the present. These costs stem from certain

quantifiable behavioural changes from the status quo.1 While the net cost of a properly

designed carbon tax is negative (i.e. produces global welfare gains), there is indeed a

positive gross cost in the present. This gross cost is usually expressed in terms of

reductions in current GDP growth for some countries or regions, including possible losses

in employment. Implementation of a carbon tax has therefore been a rather unattractive

tool for policy makers.

The second dividend is reduced unemployment

This dividend is achieved via reductions in distortionary labour taxes, financed through

carbon tax revenue. Distortionary labour taxes can include many types of labour costs,

such as wage taxes and social security contributions.