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Executive Summary

Tax Shifting and the Likelihood of Double-Dividends: Theoretical and Computational Issues

February 2000
By Alan Sanstad And Gary Wolff

Economists agree on how to protect the earth's climate at minimum cost to society. Most of them, including the 2,500 economists who signed the Economists' Statement on Global Climate Change, believe that a market-based approach to climate protection is far more efficient than traditional command-and-control policies (e.g., restrictions on emissions imposed on each factory). More specifically, they agree that using revenue from auctioned greenhouse gas emissions permits, or revenue from atmospheric user fees (so-called "carbon taxes"), to reduce existing taxes would be far better for economic efficiency than other policies. Such an environmental tax reform (ETR) is the lowest cost way to provide climate protection. But despite this consensus, some members of the U.S. Congress have been opposed to climate change policies because they believe such policies are too costly.

This idea that environmental policy can be good in both of the ways cited--an environmental benefit and an economic benefit--is often referred to as a "double dividend." A stronger claim, the "strong double dividend hypothesis," is that using revenues from permit auctions or environmental fees in this way will always improve economic efficiency even in the absence of environmental benefits. This stronger hypothesis, if true, would have profound implications for climate policy. It would mean that climate policy that generates revenue that is then used to reduce existing taxes has no cost to the U.S. economy.

Following early optimism on the topic, it has been demonstrated that this hypothesis is incorrect. Although revenue recycling can improve efficiency neglecting environmental benefits, it will not always do so. So "strong double dividends" are possible, but they are not automatic. But when will they occur? Even if they can't be obtained easily or often, climate or other environmental policies that yield strong double dividends are very powerful, politically. When strong double dividends are available from a particular tax reform, a very broad constituency of environmentalists and others can agree the policy is worth adopting, and a very powerful win-win outcome exists for society.

Although revenue recycling can improve efficiency neglecting environmental benefits, it will not always do so. So "strong double dividends" are possible, but they are not automatic.

Some economists have claimed that strong double dividends will not occur in "typical" circumstances (that is, they are unlikely, as a practical matter). Sanstad and Wolff point out that what is typical is not clear, empirically, and that the assumptions embedded in empirical tools like econometric or statistical analysis and general equilibrium modeling can influence one's findings on this question. This paper makes helps economists understand some of the underlying obstacles to be hurdled in future research on the double dividend question. The paper is written in the language of economics; non-economists are advised to wait for the popular version.

Analytical Models

Sanstad and Wolff review the results of recent static, analytical research on this topic. Static models examine the effects of a policy on the equilibrium of an unchanging (timeless) economy. The basic assumptions of economic analysis of this type--rational behavior and competitive markets--imply that strong double dividends can occur under a wide variety of conditions. The less favorable findings are based on assumptions that may or may not be empirically valid. Interestingly, a recent paper (1999) by Ian Parry of the Resources for the Future Foundation shows that strong double dividends can be found under at least one condition that seems empirically valid. 1

The possibility of strong double dividend outcomes from an environmental tax with revenues used to reduce an existing tax is a critical issue for future economic and environmental policy. When and if such outcomes can be achieved, environmental benefits are obtained at no economic cost. Even if such outcomes are rare, understanding when they are within reach, practically, is worthy of much further research.

Computable General Equilibrium Models

Because the question of strong double dividends cannot be resolved in theory alone, Sanstad and Wolff proceed to examine computable general equilibrium (CGE) models that blend theoretical structures with empirical data in order to predict how policy changes affect economic behavior and outcomes, and capture more detail on the workings of the economy than theory alone. Economists involved in the climate debate have increasingly relied on large-scale numerical simulation models to analyze alternative climate policies. Different versions of such models have yielded contradictory conclusions regarding strong double dividends from carbon taxes or auctioned carbon permits with revenues used to reduce labor or capital taxes. In order to encourage further efforts to resolve these contradictions, Sanstad and Wolff examine two well known and well documented CGE models.

A model by Lawrence Goulder at Stanford University has consistently found that strong double dividend outcomes would not result from this type of ETR, while the Jorgenson-Wilcoxen model has found that double dividend outcomes are possible if carbon or energy tax revenues are used to reduce taxes on capital income. There is as yet no agreement as to the source of this discrepancy. There are a number of possible reasons, however, that are worthy of further investigation. For example, new capital goods become less energy intensive in the Jorgenson-Wilcoxen model after energy prices rise, while they continue to use just as much energy in the Goulder model after energy prices rise. Structural differences between the models also seem to have implications for the findings from the models. Understanding how various assumptions affect model outputs, then performing empirical investigations to find out which assumptions more accurately reflect the real economy, would greatly help to identify when and if strong double dividends will result from any type of ETR, not just carbon tax related ETRs.

Conclusion

The possibility of strong double dividend outcomes from an environmental tax with revenues used to reduce an existing tax is a critical issue for future economic and environmental policy. When and if such outcomes can be achieved, environmental benefits are obtained at no economic cost. Even if such outcomes are rare, understanding when they are within reach, practically, is worthy of much further research. Sanstad and Wolff lay the groundwork for researchers to develop better empirically based models or evaluations.

Note: Executive Summary prepared by Gary Wolff.

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