Concern about the environment has led to many proposals for markets in pollution permits or for corrective taxes on polluting activities, which typically ignore governments' need to raise taxes for public spending. In Discussion Paper No. 745, Research Fellows Lans Bovenberg and Frederick van der Ploeg consider how governments can internalize environmental externalities while also raising revenues when a sizeable public sector creates serious tax distortions. They dispute the `double dividend' hypothesis: that raising the dirt tax while cutting the labour tax both improves the environment and raises employment and the tax base. If dirt taxes shift private consumption towards cleaner goods, this erodes the base of distortionary taxes so employment will typically fall, while increased environmental concern can also raise the cost of public consumption.

If the elasticity of substitution between private goods and leisure is small while that between clean and dirty goods is large, they advocate reducing public consumption to improve the environment by changing the composition of activity. If substitution between clean and dirty commodities is more difficult, reduced production and increased leisure are required, but the public sector can expand if the substitution effects of lower after-tax wages are large. If public consumption increases, the dirt tax falls, the labour tax rises, abatement falls, the composition of public and private activity becomes dirtier, provision of (conventional) public goods rises and the volume of marketable goods and private welfare fall. Finally, Bovenberg and van der Ploeg suggest extending their analysis to address equity as well as efficiency and to consider an open economy, polluting factors of production, pollution as a by-product of production, and rent-seeking.

Environmental Policy, Public Finance and the Labour Market in a Second-best World
Lans A Bovenberg and Frederick van der Ploeg

Discussion Paper No. 745, November 1992 (IM/AM)