Tax Theory and Economic Analysis: Double Dividend Hypothesis

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Broadly, the double dividend hypothesis suggests that environmental taxes can provide two benefits. The first benefit, or dividend, is an improvement in environmental health. The second dividend results from the use of environmental tax revenue to reduce other ‘distortionary’ taxes, such as income taxes that distort labor supply and saving decisions. The hypothesis was first advanced by Tullock in his paper “Excess Benefit” (1967).

Pigou established that the optimal tax rate is equal to marginal social damages (MSD) in the absence of revenue-motivated taxes. The question of whether this optimal rate rises or falls relative to MSD when revenue-raising taxes are in effect is understood to be an indirect test of whether there is a second benefit, or “double dividend”, when revenue is recycled. The validity of the double dividend hypothesis largely centers on this question. There is some agreement that under certain conditions the optimal tax rate could be higher than MSD when revenue from the environmental tax is recycled (Swartaz and Repetto, 2000).

The influence of environmental taxes, used in conjunction with revenue raising taxes, on optimal levels of environmental quality is also often analyzed. Gaube (1998) provided a definitive answer from a theoretical economics perspective. Revenue-raising taxes discourage the consumption of goods and services generally, including those that have harmful environmental effects. Thus, the introduction of an environmental tax alongside existing revenue-raising taxes will generally lower the level of pollution in the economy beyond the optimal target defined by the environmental tax rate.