Environmental Economics
Optimal taxation

While industrialists worry that environmental protection measures may induce capital flight and reduce private income, environmentalists propose the `double dividend' hypothesis: that taxing pollution and reducing distortionary taxes on labour can improve the environment and also boost employment and hence the tax base. In Discussion Paper No. 785, Research Fellows Lans Bovenberg and Frederick van der Ploeg extend their previous work, which refuted this for taxes on consumption pollution for a closed economy. They consider production pollution for a small open economy in which immobile labour and internationally traded capital and natural resources enter as factors in production, and households choose between consumption of goods and leisure.

Bovenberg and van der Ploeg show that introducing more `environmentally-friendly' taxation policies to raise the share of labour in relation to natural resources still tends to reduce employment. If the marginal productivity of public abatement falls rapidly with its level, and labour supply is price elastic while that of natural resources inelastic, any environmental improvement is achieved mainly by reducing the level rather than changing the composition of economic activity. `Red' and `green' preferences will then be compatible, since public consumption rises with concern for the environment. If resources substitute closely for capital but not for labour, however, improved environmental standards may be compatible with raising output with a cleaner composition of activity. Public consumption falls as environmental concern increases, since it crowds out public abatement.

Bovenberg and van der Ploeg also show that a discovery of new natural resources that are wholly owned by the government will generate extra public revenues and permit increased public consumption without affecting private behaviour or environmental policy. A higher world price of natural resources will raise public revenues without affecting the resource tax or the level of public abatement; it will nevertheless improve the environment by making production less resource intensive.

Green Policies in a Small Open Economy
A Lans Bovenberg and Frederick van der Ploeg

Discussion Paper No. 785, May 1993 (IM)