Tax Deductible Spending, Environmental Policy, and the "Double Dividend" Hypothesis

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1 Tax Deducible Spending, Environmenal Policy, and he "Double Dividend" ypohesis Ian W.. Parry Anonio Miguel Beno Discussion Paper February P Sree, W Washingon, DC Telephone Fax Inerne: hp:// 999 Resources for he Fuure. All righs reserved. o porion of his paper may be reproduced wihou permission of he auhors. Discussion papers are research maerials circulaed by heir auhors for purposes of informaion and discussion. They have no undergone formal peer review or he ediorial reamen accorded RFF books and oher publicaions.

2 Tax Deducible Spending, Environmenal Policy, and he "Double Dividend" ypohesis Ian W.. Parry and Anonio Miguel Beno Absrac A number of recen sudies have shown ha he general equilibrium welfare effecs of exernaliy-correcing policies depend imporanly on pre-exising axes in he economy, paricularly hose ha disor he labor marke. This paper exends he prior lieraure by allowing for consumpion goods ha are deducible from labor axes. These "goods" represen medical insurance, oher less angible fringe benefis, morgage ineres, and so on. The iniial ax sysem effecively subsidizes ax-favored consumpion relaive o oher consumpion, in addiion o disoring he labor marke. We find ha incorporaing ax-favored consumpion may overurn key resuls from earlier sudies. In paricular, a revenue-neural polluion ax (or aucioned polluion permis) can produce a subsanial "double dividend" by reducing boh polluion and he coss of he ax sysem. The second dividend arises because he welfare gain from using environmenal ax revenues o cu labor axes is much larger when labor axes also disor he choice among consumpion goods. Indeed (ignoring environmenal benefis) he overall coss of a revenueneural polluion ax are negaive in our benchmark simulaions, a leas for polluion reducions up o 7 percen, and possibly up o 42 percen. In addiion, we show ha he presence of ax-favored consumpion may dramaically increase he efficiency gain from using (revenue-neural) emissions axes (or aucioned emissions permis) over grandfahered emissions permis. Key Words: environmenal policies, disorionary axes, ax deducions, welfare effecs JE Classificaion umbers: 23, Q28, 5 ii

3 Table of Conens. Inroducion Concepual Framework... 4 A. Assumpions... 4 B. The Welfare Effecs of Environmenal Policies... 5 C. Relaion o Previous Sudies umerically-solved Model... A. Funcional Forms... B. Model Calibraion Resuls...5 A. Marginal Coss...5 B. Toal Coss...7 C. Relaive Polluion Inensiies...20 D. Welfare under he Pigouvian Rule...2 E. Opimal Policies...22 F. Caveas Conclusions...24 Appendix A: Formal Derivaion of Welfare Effecs...26 Appendix B: Deriving a Formula for he MEB...30 Appendix C: The Relaionship beween he Elasiciy of Taxable Income and Key Parameers in our Analysis...3 References...32 is of Figures and Tables Figure... 6 Figure 2 Marginal Coss...6 Figure 3 Toal Coss...8 Figure 4 Varying he Polluion Inensiy of Tax-Favored Consumpion...20 Figure 5 Welfare under he Pigouvian Rule...22 Figure 6 Opimal Policies...23 Table Alernaive Scenarios for Key Parameers...4 iii

4 TA DEDUCTIBE SPEDIG, EVIROMETA POICY, AD TE "DOUBE DIVIDED" YPOTESIS Ian W.. Parry and Anonio Miguel Beno *. ITRODUCTIO In recen years here has been a good deal of debae among academics and policy makers abou he ineracions beween environmenal policies and he ax sysem. These debaes arose in response o he so-called "double dividend" hypohesis, ha is he claim ha environmenal axes could simulaneously improve he environmen and reduce he economic coss of he ax sysem. The laer effec seemed plausible, if he revenues from axes on carbon emissions, gasoline, raffic congesion, household garbage, fish caches, chemical ferilizers, and so on, were used o reduce he raes of pre-exising axes ha disor labor and capial markes. Indeed i was suggesed ha he overall coss of revenue-neural environmenal axes migh be negaive. If so, i would no be necessary o know he benefis from environmenal improvemen--which are ofen highly uncerain--in order o jusify an environmenal ax on cos/benefi crierion. owever, a number of recen analyical and numerical analyses have cas doub on he validiy of he double dividend hypohesis. The basic poin is ha he hypohesis ignores an imporan source of ineracion beween environmenal axes and pre-exising axes. Since environmenal axes raise he coss of producing oupu hey end o discourage (slighly) labor supply and invesmen, and hereby exacerbae he efficiency coss associaed wih ax disorions in labor and capial markes. In fac, aside from cerain special cases, hese sudies find ha he coss from his ineracion effec dominae any efficiency benefis from recycling environmenal ax revenues in oher ax reducions. Tha is, he presence of pre-exising ax disorions raise he coss of environmenal axes. The models in he recen lieraure ypically assume a uniform ax on labor (and possibly capial) income wih no ax deducions. Thus, in hese models he only he only * Ian W.. Parry, Resources for he Fuure; Anonio Miguel Beno, Universiy of Maryland. We graefully acknowledge he helpful commens and suggesions of Dallas Burraw, Alan Krupnick, Richard ewell, Wally Oaes, Mike Toman, Rob Williams, and seminar paricipans a Resources for he Fuure. We also hank he Environmenal Proecion Agency (Gran R825330) for financial suppor. Correspondence o: Ian Parry, Resources for he Fuure, 66 P Sree, Washingon, D.C Phone: (202) We do no go ino he deails of individual sudies here since he rise and fall of he double dividend hypohesis has been discussed a lengh in oher places. For recen surveys of he lieraure see Bovenberg and Goulder (998), Parry and Oaes (998), Goulder (995a) and Oaes (995). Our discussion is concerned wih models ha assume a compeiive labor marke, which is probably a reasonable approximaion a leas for he U.S. economy. The general equilibrium welfare effecs of environmenal policies are more complex when he labor marke conains significan insiuional disorions which make he real wage "sicky" (see e.g. Bovenberg and van der Ploeg, 998).

5 Parry and Beno RFF source of price disorion creaed by he ax sysem is in facor markes. owever, cerain ypes of spending are (a leas parially) deducible from labor axes. This includes, among oher hings, spending on morgage ineres, employer-provided medical insurance, and oher less angible fringe benefis. 2 In pracice, herefore, he ax sysem creaes an addiional source of price disorion: i effecively subsidizes ax-favored spending relaive o all oher, non-ax-favored spending. Indeed some recen evidence poins o he empirical significance of his second source of economic disorion. Tradiionally, esimaes of he welfare cos from raising labor axes o finance governmen ransfers are in he order of 30 cens per dollar of revenue raised-- alhough here is a fair amoun of uncerainy concerning hese esimaes (see e.g., Browning, 987; Snow and Warren, 996). These sudies focus on he welfare impacs in he labor marke alone. owever, some very recen work suggess ha hese welfare coss may be subsanially higher--possibly wo or hree imes as high--when he subsiuion beween axfavored consumpion and ordinary (non-ax-favored) consumpion is aken ino accoun (Feldsein, 995a). This paper exends previous lieraure by exploring he implicaions of ax-favored consumpion for he general equilibrium coss, and overall welfare effecs (benefis less coss) of environmenal policies. We model a saic economy where households allocae heir ime beween leisure and labor supply. abor, along wih a clean inpu and a polluing inpu (e.g., energy or fossil fuels), is used o produce wo consumpion goods. Expendiure on one of he consumer goods is (parially) deducible from labor axaion. U.S. daa on labor marke parameers is used o calibrae he model. A firs glance, one migh hink ha if he disorionary coss of pre-exising axes are greaer han assumed in earlier sudies, hen he general equilibrium coss of new environmenal policies would also be greaer. owever we find he opposie resul is ypical for environmenal axes wih revenues used o cu personal income axes. Tha is, he presence of ax-favored consumpion can subsanially reduce he coss of environmenal axes (relaive o heir coss in he absence of ax deducions). In fac, resuls on he double dividend hypohesis esablished in he earlier lieraure can easily be overurned, even under very conservaive esimaes for he coss of pre-exising axes. In our benchmark simulaions, ignoring any environmenal benefis, he ne impac of an environmenal ax swap is o reduce he overall economic coss of he ax sysem for polluion reducions up o a leas 60 percen. In oher words he general equilibrium coss of he policy are less han he parial equilibrium coss, and by a poenially subsanial amoun. Indeed he overall coss of polluion reducion are negaive for axes ha reduce polluion by 7 percen, and possibly up o 42 percen. A relaed poin is ha, in conras o ypical resuls from earlier sudies (e.g., Bovenberg and 2 There are a variey of oher major deducions from federal income axes, such as hose for pension and chariable conribuions, local income axes, acceleraed depreciaion, and so on. owever, for reasons discussed below we do no consider hese oher deducions o be relevan for our paricular analysis. 2

6 Parry and Beno RFF Goulder, 996; Parry, 995) we find he opimal environmenal ax may easily exceed he Pigouvian ax. These resuls arise because he welfare gain from using environmenal ax revenues o reduce labor axes is higher, and perhaps subsanially so, when labor axes disor he relaive prices among consumpion goods in addiion o he price of labor. In conras, (roughly speaking) he ineracion effec menioned above does no change because environmenal axes have approximaely he same impac on raising he price of consumpion goods relaive o leisure. Also, a leas in he case when he polluion inensiy is he same in boh he axfavored and he non-ax-favored consumpion secors, he environmenal ax does no aler he relaive price of he wo consumpion goods, and hence does no exacerbae he coss of he subsidy o ax-favored consumpion. Since he gains from recycling environmenal ax revenues are larger, while he cos of he ineracion effec is no, he welfare coss of he environmenal ax are lower--and quie possibly of opposie sign--han in earlier models. We also explore he implicaions of ax-favored consumpion for he coss of oher policy insrumens. We find ha he coss of non-aucioned polluion emissions permis, or polluion axes whose revenues are reurned lump-sum (raher han used o reduce disorionary axes), could be significanly greaer or significanly less han found in previous sudies, depending on he relaive polluion inensiy of he ax-favored consumpion secor. In addiion, regardless of he relaive polluion inensiy, he welfare gain from using revenueneural emissions axes (or aucioned emissions permis) insead of non-aucioned permis can be dramaically higher han suggesed by earlier sudies. This is due o he larger efficiency gain from using revenues from environmenal policies o reduce labor axes in he presence of ax-favored consumpion. In many of our simulaions here is much more a sake in wheher environmenal policies raise revenues, and how hese revenues are recycled, han he (parial equilibrium) welfare gain from correcing he environmenal exernaliy. There are a number of imporan caveas o our analysis (hese are discussed in more deail below). Firs he absolue--hough no he relaive--coss of emissions axes and emissions permis are sensiive o he relaive polluion inensiy of he ax-favored secor. owever, even when he polluing inpu is used significanly less inensively in he axfavored secor here is sill he prospec for a subsanial double dividend, a leas for modes levels of polluion reducion. Second, in pracice he disorion beween marginal social benefi and marginal social cos in he marke for ax-favored consumpion is a good deal more complicaed han assumed in our analysis. There are a number of possible eernal benefis, exernal coss, oher regulaions, and subsidies ha affec he overall size of his disorion. owever he empirical imporance of hese facors, and wheher heir ne impac is o increase or decrease he size of he disorion, is unclear. Third, here is also uncerainy abou wo oher imporan parameers in our model, namely he elasiciy of demand for axfavored consumpion and he labor supply elasiciy. Given hese uncerainies, we illusrae he welfare effecs of environmenal policies over a wide range of scenarios for parameer values, raher han emphasizing specific poin esimaes. These simulaion exercises clearly illusrae he seemingly crucial imporance of 3

7 Parry and Beno RFF accouning for ax-favored spending. They also highligh he usefulness of fuure empirical sudies ha migh provide more accurae esimaes of cerain key parameers. The res of he paper is organized as follows. Secion 2 discusses he welfare effecs of alernaive environmenal policies in he presence of ax-favored consumpion. Secion 3 describes our numerical model and Secion 4 provides he simulaion resuls. Secion 5 offers conclusions. 2. COCEPTUA FRAMEWORK In his secion we explain he general equilibrium welfare effecs of alernaive environmenal policies in he presence of (parially deducible) labor axaion, wih he aid of diagrams and cerain key formulas. This provides a concepual framework for inerpreing he subsequen numerical resuls. We provide a more rigorous mahemaical model, and he derivaion of he formulas, in Appendix A and B. 3 A he end of his secion we relae our resuls o hose in earlier sudies. A. Assumpions Consider a saic economy where wo final goods and Y are produced using labor and inermediae goods. denoes "ax-favored" consumpion and represens an aggregae of consumpion goods ha are (a leas parially) deducible from labor axes. These "goods" include (morgage ineres paid on) owner-occupied housing, oher deb-financed spending secured by real esae, child care expendiures, and so on. They also include non-wage compensaion such as employer-provided medical insurance, life insurance, business lunches, healh clubs, and so on. 4 Y denoes an aggregae of consumpion goods ha do no receive preferenial ax reamen. There is a polluing inermediae good Z (e.g. coal), and a clean inermediae good C, boh of which are produced using labor. ousehold uiliy is adversely affeced by polluion. For simpliciy, assume ha polluion damages per uni of Z are consan φ. 5 In addiion we 3 The mahemaical derivaions of he welfare effecs (see Appendix A) are similar o hose in a number of recen models of environmenal policies in he presence of labor axes (e.g. Goulder e al., 997, 998; Parry e al., 998). In paricular, he analyical model in Parry e al. would be almos equivalen o ha in he curren paper, following he inroducion of a subsidy for one of he wo consumpion goods in heir household and governmen budge consrains. Thus, we hink here is more value added from using a diagrammaic approach in he above secion, in which he inuiion is more ransparen, and we relegae he (parially repeiive) mahemaical proofs o he Appendix. 4 A firs glance i migh seem ha ax-favored consumpion should also include black marke aciviies where cash ransacions are no repored as axable income (possible examples include he hiring of nannies and gardeners). owever since hese aciviies are no observed hey are implicily couned as leisure aciviies, and hence are capured in sudies ha esimae how axes affec he subsiuion from observed labor supply ino leisure. 5 Some oher models (e.g. Goulder e al., 997) allow for he possibiliy ha polluion per uni of he diry inpu can be reduced, hrough he adopion of end-of-pipe abaemen echnologies. owever, his exension has very lile impac on he relaive welfare impacs of polluion axes and permis. 4

8 Parry and Beno RFF assume ha producion is compeiive and characerized by consan reurns o scale, herefore supply curves are perfecly elasic. We represen he ax sysem by assuming he governmen levies wo axes on gross labor earnings: a "comprehensive" labor ax C and a "non-comprehensive" ax. Expendiure on is deducible from he non-comprehensive ax bu no expendiure on Y. eiher good is deducible from he comprehensive ax. 6 The governmen reurns all revenues in a lump-sum ransfer (G) o he household secor. The (aggregae) household budge consrain amouns o: ( ) p + p Y = ( ) G (2.) Y C + where p and p Y are he producer prices of and Y which we normalize o uniy in he iniial equilibrium. is labor supply, which is responsive o he (ne-of-ax) real wage, since households gain uiliy from leisure. oe ha he ax sysem effecively axes labor income and subsidizes he consumpion of. Figure depics he equilibrium in each of he hree disored markes in he economy. These are he polluing inpu marke (upper panel), he marke for ax-favored consumpion (middle panel) and he labor marke (boom panel). Demand and supply curves are denoed by "D" and "S" and iniial quaniies by subscrip 0. MSC Z denoes he marginal social cos of he polluing inpu which equals he supply price plus environmenal damages per uni. In he labor marke he demand curve is perfecly elasic, while he supply curve is upward sloping, reflecing he increasing marginal social cos of labor ime. 7 B. The Welfare Effecs of Environmenal Policies Suppose a ax of τ = φ is imposed on he polluing inpu and, for he momen, ha he revenue consequences of his policy are neuralized by changing he lump sum ransfer. The general equilibrium welfare change from his policy consiss of he welfare impacs in each of he hree disored markes (see Appendix A for a proof): (i) Pigouvian welfare gain. Imposing a ax of τ=φ on he polluing inpu reduces he quaniy o Z in Figure (a). This produces environmenal benefis equal o recangle abcd, or environmenal damages per uni of Z muliplied by he reducion in Z. 8 I also produces economic coss of riangle acd, which we call he primary cos of he policy. This equals he 6 In pracice some componens of, such as non-wage compensaion, are deducible from all labor axaion, ha is boh personal income and payroll axes. Oher componens of, such as morgage ineres, are deducible from income axes bu no payroll axes. 7 Our assumpion of consan reurns o scale, and ha labor is he only primary inpu, imply a fla labor demand curve. On he supply curve, a worker well o he lef of 0 has a relaively low opporuniy cos o being in he labor force and someone well o he righ of 0 would have a relaively high cos o being in he labor force. The laer may represen, for example, he parner of a working spouse who enjoys looking afer he house and children. 8 The change in Z is general equilibrium, ha is, afer he environmenal ax revenues have been reurned in exra ransfers. 5

9 Parry and Beno RFF Figure Price Z D (a) +φ f a b MSC Z e d c S Z Z Z 0 Polluing inpu (b) Price D P P 0 S S 0 ( ) P ( ) P 0 0 Tax-favored consumpion Wage (c) S S 0 D C 0 abor 6

10 Parry and Beno RFF reducion in consumer surplus (rapezoid acz 0 Z ), less he reducion in producion coss (recangle dcz 0 Z ). Environmenal benefis less he primary cos leaves he Pigouvian welfare gain, equal o he shaded riangle. (ii) Subsidy-ineracion effec. In he marke for ax-favored consumpion here is a wedge of beween he supply price (equal o he marginal social cos of ) and he p demand price (equal o he marginal social benefi). The environmenal ax raises he coss of producing and his shifs he supply curve from S 0 o. The demand price increases from ( o p ) 0 ( and oupu falls o. This produces a welfare gain in his p ) marke equal o he shaded parallelogram. Tha is, for each uni reducion in he reducion in social coss exceeds he reducion in consumer benefis by he wedge beween he supply and demand price,.9 We refer o his welfare effec as he subsidy-ineracion effec. p The size of he subsidy-ineracion effec relaive o he primary cos depends on he size of he parallelogram relaive o riangle acd. The relaive heigh of hese wo areas reflecs he rae of subsidy relaive o he rae of environmenal ax. The base of he parallelogram relaive o he base of he riangle depends on wo imporan facors. Firs, he easier i is for firms o subsiue oher inpus in producion (labor and he clean inpu) for he diry inpu Z, he smaller will be he change in relaive o he change in Z. Second, noe ha Z is also an inpu in he producion of Y and hence he environmenal ax will drive up he price of Y. The greaer he increase in price of Y (relaive o he increase in price of ) he smaller will be he reducion in. Indeed (as illusraed below) if Z is used more inensively in Y han in he change in could acually be posiive, hereby reversing he sign of he subsidy-ineracion effec. Our numerical simulaions show ha he subsidy-ineracion effec is an empirically imporan deerminan of general equilibrium welfare coss when he relaive polluion inensiy differs markedly across he and Y indusries. (iii) Tax-ineracion effec. The posiion of he labor supply curve in Figure (c) depends on he prices of consumpion goods. In paricular, he increase in price of and Y caused by he environmenal ax reduces he amoun of consumpion ha can be purchased from a given nominal (ne-of-ax) wage. Tha is, he environmenal ax indirecly reduces he reurn o work effor relaive o leisure and his ypically causes he labor supply curve o shif upwards (slighly) o S. abor supply falls from 0 o and his produces a welfare loss equal o he shaded recangle. This recangle equals he wedge beween he gross wage (uniy)--which equals he value marginal produc of labor--and he ne of ax wage (( C ))--which equals he opporuniy cos of an incremenal reducion in leisure--muliplied by he reducion in labor S 9 This is a simple applicaion of he familiar formulas for he general equilibrium welfare effec of a new ax in he presence of pre-exising price disorions (see e.g. arberger, 974, chapers. 2 and 3, and Appendix A below). oe ha a new ax causes a second-order welfare effec (i.e. riangle) in he marke where i is imposed (in his case he polluing inpu marke). I causes a firs-order welfare effec (a recangle or parallelogram) in any oher marke of he economy where quaniies change and where here is a pre-exising price disorion (in his case an oupu marke). 7

11 Parry and Beno RFF supply. This is he ax-ineracion effec, which is familiar from oher sudies (e.g. Goulder e al., 997; Parry, 995). For he environmenal ax wih lump-sum replacemen hese hree componens consiue he general equilibrium welfare effec of he policy (Appendix A). ow however, suppose ha one of he wo labor axes adjuss o mainain budge balance insead of he lump-sum ransfer. In his case an addiional welfare effec comes ino play. (iv) Revenue-recycling effecs. The ne revenue received by he governmen is somewha less han he revenue raised in he polluing inpu marke, φz in Figure (a), due o he loss of labor ax revenues in Figure (c). 0 Suppose ne revenues equal recangle fade in Figure (a). If his revenue is used o reduce he non-comprehensive ax insead of increasing he lump-sum ransfer, his produces wo sources of welfare gain. Firs, his (slighly) raises he ne-of-ax wage leading o an increase in labor supply. Second, i also (slighly) reduces he relaive subsidy for and herefore induces a subsiuion ou of ax-favored consumpion and ino non-ax-favored consumpion. The combined welfare gain from hese wo effecs, per dollar of revenue recycled, is denoed MEB. This is equivalen o he marginal excess burden (MEB) of non-comprehensive labor axaion, ha is he welfare cos from spending an exra dollar of lump-sum ransfers financed by increasing he non-comprehensive labor ax. The oal welfare gain from using he polluion ax revenues o cu he non-comprehensive labor ax is MEB imes recangle fade. We refer o his as he revenue-recycling effec. 2 Suppose insead ha ne revenues are used o reduce he comprehensive labor ax. In his case here is a similar welfare gain in he labor marke, bu no gain from reducing he subsidy wedge in he marke for ax-favored consumpion. Therefore (for he same amoun of revenues raised) he welfare gain from he revenue-recycling effec is smaller, MEB C imes recangle fade, where MEB C is he MEB for he comprehensive labor ax and MEB C <MEB. We say here is a "srong" revenue-recycling effec when he non-comprehensive labor ax is reduced and a "normal" revenue-recycling effec when he comprehensive labor ax is reduced. Emissions Permis ow suppose he quaniy of he polluing inpu is reduced o Z in Figure (a) by issuing he appropriae quaniy of polluion permis. This policy induces he same Pigouvian welfare gain as he environmenal ax. I also induces an analogous subsidy-ineracion effec 0 Alhough his revenue loss is parially offse o he exen ha ax-favored consumpion falls. The direc revenues from he environmenal ax are likely o easily dominae he loss of labor ax revenues, excep when environmenal axes approach prohibiive levels (Parry, 995). The welfare gain in he labor marke is (approximaely) equal o he increase in labor supply muliplied by he wedge beween he gross and ne wage. The welfare gain in he marke equals (approximaely) he reducion in muliplied by he rae of non-comprehensive ax. 2 The revenue-recycling and ax-ineracion effecs are familiar from earlier sudies. For ease of exposiion, we use a slighly differen definiion here. Oher sudies (e.g. Parry, 995; Goulder e al., 997) add on he welfare loss from he reducion in labor ax revenues o he cos of he ax-ineracion effec, raher han subracing i from he revenue-recycling effec, as we have above. 8

12 Parry and Beno RFF and ax-ineracion effec because i raises he price of he polluing inpu o he same level (+φ). The permi policy creaes rens of recangle φz. If he permis were aucioned he rens would accrue o he governmen and he general equilibrium welfare effec of he policy would be idenical o ha of he environmenal ax in our model. Insead, in keeping wih pracice so far in U.S. polluion conrol programs, we assume he permis are given ou for free o exising firms. In his case he rens accrue o he privae secor. The governmen does (indirecly) receive a fracion of hese rens because rens are refleced in firm profis (which are subjec o corporae income ax) and ulimaely non-labor household income (which is subjec o personal income ax). owever, his revenue gain is (slighly) more han offse by he reducion in labor ax revenues in our simulaion resuls. C. Relaion o Previous Sudies In previous sudies (e.g. Goulder e al., 997; Bovenberg and de Mooij, 994; Parry, 995) here is no allowance for ax-favored spending and hence no disorion in he marke in Figure (b). 3 The general equilibrium cos of a revenue-neural polluion ax in hese models herefore consiss of he primary coss, he ax-ineracion effec, and he normal revenue-recycling effec. These sudies ypically find ha he cos from he ax-ineracion effec dominaes he benefi from he normal revenue-recycling effec. Therefore, he ne impac of environmenal ax swaps is o reduce labor supply and increase he coss of preexising axes. 4 These sudies herefore cas doub on he "double dividend" hypohesis, ha is he claim ha environmenal axes could boh improve he environmen and reduce he coss of he ax sysem a he same ime. 5 3 awrence Goulder has used a sophisicaed dynamic numerical model of he US economy o conduc a number of exercises ha examine he effecs of environmenal axes (see e.g. Goulder, 995b). Alhough i allows for a deailed reamen of he ax sysem, his model does no incorporae ax deducions for medical insurance and morgage ineres. 4 These resuls are consisen wih earlier resuls from he public finance lieraure (see e.g. Sandmo, 976). The environmenal ax swap effecively subsiues revenues from a ax wih a relaively narrow base (for example fossil fuels or energy oupu) for revenues from a ax wih a very broad base (economy-wide labor income). arrow based axes ypically involve higher coss because he subsiuion possibiliies for avoiding he ax are much greaer han when he ax has a broad base. 5 This hypohesis sems from analyses ha essenially "ack on" he revenue-recycling effec o a parial equilibrium analysis of environmenal axes. Since hey are no general equilibrium, hese analyses fail o capure he crucial ax-ineracion effec. A double dividend could however arise in some special cases. For example, if oupu from he polluing secor is a relaively weak subsiue (or complemen) for leisure compared wih oher marke oupus hen he revenue-recycling effec can dominae he ax-ineracion effec (his may apply, for example, in he case of cigaree axaion or axes on polluing inpus in agriculure). Also, o some exen incorporaing capial can eiher srenghen or weaken he resuls from saic, one-facor models. This depends on he exen o which he MEB of labor and capial axes differ and he exen o which he environmenal ax swap may shif he overall burden of axaion from one facor o anoher. Finally, changes in environmenal qualiy may have feedback effecs ha affec he labor/leisure decision. These feedback effecs are no capured in he empirical models because hey are difficul o quanify. We absrac from all hese complicaions below since hey have been discussed a lengh in he lieraure (see e.g. he survey in Bovenberg and Goulder, 998). 9

13 Parry and Beno RFF Our numerical resuls below differ from hose in hese earlier sudies because of he subsidy-ineracion effec, and more imporanly o he exen ha he srong and normal revenue-recycling effecs differ. The raio of he srong o he normal revenue-recycling effec equals MEB /MEB C. In Appendix B we derive he following formula for MEB (when τ = 0 and we ignore feedback effecs on he environmen): MEB ε = M ε + s s η + η M (2.2) M where ε and supply elasiciies, ε are he uncompensaed (Marshallian) and compensaed (icksian) labor M η and η are he uncompensaed and compensaed own price elasiciy of demand for ax-favored consumpion (expressed as posiive numbers), s is he share of ax-favored consumpion in oal consumpion and = C + is he oal labor ax wedge. Seing =0 gives: MEB C ε ε M (2.3) The formula in (2.3) has been discussed a lengh in oher sudies (see e.g. Browning, 987, and Snow and Warren, 996) and we do no go ino deails here. 6 For our purposes he key poin here is ha he increase in he MEB because of ax-favored consumpion depends on hree key parameers (which we discuss below): he relaive size of he ax-favored consumpion secor, he (compensaed and uncompensaed) demand elasiciy for ax-favored consumpion, and he subsidy wedge. 6 These formulas are for an increase in labor axaion o finance an exra dollar of he lump-sum ransfer. If he exra revenue were no reurned o households (for example i wen ou of he economy in foreign aid) all he elasiciies would be uncompensaed, while if he exra public spending was sufficien o keep household uiliy consan all he elasiciies would be compensaed. In our case he formulas depend on boh uncompensaed and compensaed elasiciies because he exra revenue o be recycled from an incremenal increase in (+d/d in he case of (2.3)) does no fully compensae households for he loss in surplus from he ax increase (). The formula in (2.3) is exac when =0, as in previous sudies. The MEB for he comprehensive ax in our model is a lile more complicaed due o a cross-price effec in he marke, however in quaniaive erms he difference is very small. 0

14 Parry and Beno RFF UMERICAY-SOVED MODE We now perform numerical simulaions o compare, empirically, he welfare impacs of alernaive environmenal policies. Subsecions A and B describe he assumed funcional forms and model calibraion underlying he simulaions. Due o uncerainy over he values of key parameers, we consider "low", "medium" and "high" scenarios for he disorionary coss of he ax sysem. A. Funcional Forms The household has he following consan elasiciy of subsiuion (CES) form for uiliy: U = α U C σu σu + ( α U )( ) σu σu σu σu φ( Z) (3.) σ C σ C σ C σ C σ C σ C C = α C + ( α C ) Y (3.2) where C denoes composie consumpion or sub-uiliy from he consumpion of goods and he σ's and α's are parameers. σ U and σ C denoe he elasiciies of subsiuion beween composie consumpion and leisure, and beween individual consumpion goods, respecively. The α's are share parameers. φ(.) is disuiliy from he polluion caused by he diry inpu Z, where φ >0, φ 0. There are wo noable resricions embedded in his uiliy funcion. Firs, he separabiliy assumpion in (3.) simplifies our analysis by ruling ou possible feedback effecs of changes in environmenal qualiy on he labor/leisure decision and he choice among consumpion goods. 7 Second, he weak separabiliy beween leisure and consumpion goods, and he homoheic propery of (3.2) ogeher imply ha and Y are equal subsiues for leisure. 8 This seems a reasonable benchmark assumpion, given ha we know of no evidence o sugges ha he degree of subsiuion beween ax-deducible consumpion and leisure is significanly sronger or weaker han he degree of subsiuion beween oher consumpion goods and leisure. and Y are produced using he polluing inermediae good (Z), a clean inermediae good (), and labor using he following CES producion funcions: 7 One possible feedback effec migh occur in he case of raffic congesion. Under cerain condiions, a congesion ax on work-relaed raffic can increase he household wage ne of commuing coss, and hence raise he labor force paricipaion rae a he margin. Anoher example is he possibiliy ha reduced polluion will raise worker produciviy by improving human healh (see e.g. Williams, 998). 8 See Deaon (98) for a proof. For a discussion of how he relaive degree of subsiuion beween goods and leisure alers he welfare impac of environmenal policies, see e.g. Boveneberg and Goulder (998) and Parry (995).

15 Parry and Beno RFF σ σ σ σ σ σ σ σ + α + α C C = αdz (3.3) Y Y = Y α D Z σy σy σy σy σy σy Y σ σ + α Y Y + α Y Y C C Y Y where σ and σ Y are he elasiciy of subsiuion beween inpus in he wo indusries and he α's are inpu share parameers, and Y Z = Z + Z ; Y = + (3.4) abor is he only inpu used o produce Z and and he marginal produc of labor in each of hese inermediae goods indusries is aken o be consan and normalized o uniy. Thus: Z Z = ; abor marke equilibrium requires: Y Z = (3.5) = (3.6) Tha is, labor demanded by final and inermediae good indusries equals labor supplied by households. As discussed above, he governmen provides a lump-sum ransfer (G), levies a comprehensive ax ( C ) and non-comprehensive ax ( ) on labor income, and reduces Z eiher by a polluion ax (τ) or polluion permis. We assume he governmen budge mus balance. In he case of he polluion ax his consrain is: G = ( + ) p + τz (3.7) C Tha is, governmen spending equals labor ax revenues less deducions plus polluion ax revenue. ouseholds choose, Y and o maximize uiliy subjec o he budge consrain given by (2.). This generaes he demand funcions for goods and he labor supply funcion. Firms choose inpus o minimize producion coss and his deermines coss per uni of oupu, or producer prices. In equilibrium demand and supply are equaed in he final goods, iner-mediae goods, and labor markes, and he household and governmen budge consrains are saisfied. 9 B. Model Calibraion The consumpion/leisure subsiuion elasiciy (σ U ) is calibraed o be consisen wih esimaes of labor supply elasiciies. The economeric evidence on labor supply elasiciies has been reviewed many imes and we do no go ino he deails here (see e.g. Killingsworh, 9 We used GAMS wih MPSGE o solve he model. 2

16 Parry and Beno RFF ). For our purposes here are several imporan poins. Firs, for our highly aggregaed model he labor supply response o changes in ne wages represens he impac on average hours worked per employee and he impac on he paricipaion rae, averaged across all members (male and female) of he labor force. Second, despie numerous sudies, here is sill a fair amoun of uncerainy over he economy-wide labor supply elasiciy, and herefore i pruden o consider a range of values. Third, our model should be consisen wih esimaes for boh he compensaed and uncompensaed labor supply elasiciy. In our medium scenario for he MEB of pre-exising axes, we choose he consumpion/leisure elasiciy and he iniial raio of labor supply o he ime endowmen o imply an uncompensaed and a compensaed labor supply elasiciy of 0.5 and 0.4 respecively. These are ypical values used in previous sudies of environmenal policies (e.g. Goulder e al., 997). In our low and high MEB scenarios we use values of 0. and 0.3, and 0.25 and 0.5 respecively. 20 Following oher sudies (ucas, 990; Goulder e al., 997), we assume a marginal ax wedge in he labor marke of 40 percen, which reflecs he combined effecs of personal, payroll and sales axes. The wo larges componens of ax-favored spending are employer provided medical insurance and homeowner morgage ineres. These iems amouned o abou 5 percen and 4 percen respecively, of oal consumpion expendiures in There are a variey of oher quanifiable iems ha add abou anoher 4 percen. 22 In addiion, here are oher caegories ha are difficul o measure, such as business lunches and rips, employer-provided healh clubs, deb-financed spending secured by real esae, and so on. 23 In shor, i is ricky o pin down really accuraely he relaive size of he ax-favored consumpion secor. We assume s = 0., 0.5 and 0.2 in our low, medium, and high MEB scenarios, respecively. If all ax-favored consumpion were fully deducible from labor axes, he subsidy wedge in he marke for ax-favored consumpion would be 40 percen in our model. This is no quie 20 These values are roughly consisen wih a recen survey of opinion among labor economiss by Fuchs e al. (998), assuming a weigh of 0.6 and 0.4 for he male and female elasiciies repored in heir Table 2. 2 Direc esimaes of hese iems oversae ax-favored spending, for example morgage paymens include repaymen of principal, which is no ax-deducible. To obain he above values we used esimaes of losses in personal income ax revenues from hese deducions from Table 523 in he Saisical Absrac of he Unied Saes (995), divided by he marginal rae of personal income ax (assumed o be 0.25 percen for he average axpayer). 22 In his lis of caegories in Table 523 we include employee parking, life insurance, child care, medical claims (raher han premiums), workman's compensaion benefis and deducions for axes paid on home sales. 23 In fac we include less han 40 percen of deducions from federal income axes in our definiion of. We exclude pension conribuions, since his ax deducion is offse a leas o some exen by fuure axes on he income from savings. For more discussion of his issue see Feldsein (995a), pp Alhough chariable conribuions are ax-deducible, hey may also confer imporan exernal benefis. We exclude chariable conribuions o avoid geing ino he messy business of esimaing exernaliy benefis. There are a variey of oher deducions lised in Table 523 of he Saisical Absrac, bu which are no really relevan for our analysis. For example deducions for capial expendiures and savings are no relevan because our analysis is saic and does no capure pre-exising axes on capial. In addiion, deducions for local income axes reduce he overall rae of labor ax bu do no disor he allocaion of consumpion expendiures. 3

17 Parry and Beno RFF he case however, and we assume a subsidy of 30 percen. 24 As discussed in Secion 4, we absrac from a number of oher complicaions ha affec he overall size of he subsidy wedge. I is difficul o assess he overall demand elasiciies for ax-favored consumpion. These are deermined by he elasiciy of subsiuion beween ax-deducible consumpion and M oher consumpion goods, and s, as follows: η = ( s ) σ C + s and η = ( s ) σ C. Various sudies have esimaed demand elasiciies for individual componens of. For example, Rosen (979) esimaed he (uncompensaed) demand elasiciy for home morgages o be uniy. A recen esimae of he demand elasiciy for healh insurance is.8 (Gruber and Poerba, 994). 25 We choose σ C o imply values of,.25 and.6 for he uncompensaed demand elasiciy for in our low, medium and high MEB scenarios. Table summarizes our key parameer values. They imply an MEB from he noncomprehensive ax equal o 0.3, 0.50 and 0.9 in he low, medium and high scenarios. In earlier sudies ha neglec ax-favored consumpion (e.g. Goulder e al., 997) he MEB is around 0.3, which equals our MEB for he comprehensive ax in he medium scenario. A firs glance i may seem surprising ha he presence of ax-favored consumpion increases he MEB so much, when ax-favored consumpion is only around 0-20 percen of he size of he labor marke. owever, his is roughly offse because ax-favored consumpion is much more sensiive o changes in ax raes han labor supply. Table. Alernaive Scenarios for Key Parameers Parameer ow MEB Medium MEB igh MEB s M η η M ε ε MEB MEB C oe: See Secion 2 for noaional definiions. 24 In paricular morgage ineres is only deducible from he personal income ax, and no he payroll ax. I is subsidized a he marginal rae of income ax (averaged across individuals) which is around 25 percen. Our assumpions abou ax raes and s imply governmen revenue is percen of oal spending in our benchmark, which is approximaely consisen wih he raio of oal ax receips o ne naional produc. oe ha our srong revenue-recycling effec implicily assumes ha environmenal ax revenues are used o cu he rae of personal income ax. The revenue-recycling effec would be somewha smaller if revenues were used o cu he payroll ax, since his ax has less deducions. 25 Earlier sudies ypically find significanly lower esimaes, however Gruber and Poerba sugges ha hese sudies conain a number of mehodological problems. 4

18 Parry and Beno RFF In fac, our parameer assumpions appear o be conservaive in ligh of a recen sudy by Feldsein (995a). e found ha he MEB for he personal income ax could easily exceed a dollar, when all subsiuion possibiliies for avoiding he ax increase are aken ino accoun. To obain his value, Feldsein used esimaes from several recen sudies of he elasiciy of he personal income ax base wih respec o changes in ax raes. This elasiciy reflecs a combinaion of labor supply effecs and subsiuion ino ax-deducible spending. Feldsein's resuls sugges ha--even in our high MEB scenario--we could be significanly undersaing s and he elasiciies for ax-favored consumpion and labor supply. The relaionship beween our parameer values and Feldsein's esimaes are discussed in more deail in Appendix C. 26 We ake he elasiciies of subsiuion in he and Y indusries (σ and σ Y ) o be uniy. This is a sandard assumpion and our resuls are no sensiive o oher values. In our iniial simulaions he facor inpu raios are iniially he same in boh consumpion goods indusries, bu his is relaxed laer on. Finally, we assume he iniial value of oupu in each inermediae good indusry amouns o 0 percen of he value of oal final oupu. The relaive coss of environmenal policies are no especially sensiive o alernaive assumpions abou he size of he polluing secor in GDP (his finding is consisen wih earlier sudies). 4. RESUTS This secion presens our simulaion resuls illusraing how he ax sysem affecs he coss, overall welfare impacs, and opimal levels of environmenal policies. We also discuss some imporan caveas o he resuls. A. Marginal Coss In Figure 2 we compare he marginal cos of reducing polluion under alernaive policy insrumens up o 50 percen below pre-regulaion levels. Marginal coss are expressed as a percen of he iniial value produc of he polluing inpu. For his figure we mainly focus on qualiaive resuls, and since hese are essenially he same under all hree MEB scenarios, we jus illusrae he medium MEB case. MC PRIM indicaes marginal coss in a firs-bes case when we se pre-exising axes and he subsidy o zero. This curve reflecs primary coss only and is he same under boh he polluion ax and polluion permis. 27 MC PRIM has a zero inercep, and is upward sloping, reflecing he increasing marginal cos of subsiuing oher inpus for he polluing inpu in producion and he increasing marginal cos of reducing he amoun of consumpion. 26 We prefer no o commi ourselves o "bes guesses" for hese parameers unil more evidence becomes available. Insead we illusrae a range of oucomes under plausible values. The labels low, medium, and high MEB scenarios are used for convenience--hey do no reflec any views abou "mos likely" parameer values. 27 To calculae he primary coss we re-calibrae he disribuion parameers such ha he iniial quaniy of goods and leisure are he same as in he model wih non-zero axes. owever he subsiuion elasiciy parameers, which crucially deermine he relaive coss of policies, are he same across he models wih and wihou he labor axes. 5

19 Parry and Beno RFF Figure 2. Marginal Coss MC S 5 Marginal Cos MC COM MC SI MC PRIM 0 MC C Percenage reducion in polluion MC SI shows marginal coss when we allow for he 30 percen subsidy for, bu sill se labor axes a zero. 28 The difference beween his curve and MC PRIM reflecs he (marginal) subsidy-ineracion effec. This effec is a welfare gain (he parallelogram in Figure (b)) because he polluion ax reduces he oupu of, hus offseing o some exen he disorionary effec of he subsidy. owever, he subsidy-ineracion effec is no very large. This is because he price of and Y increase in he same proporion, and hence he reducion in reflecs subsiuion ino leisure only and no ino oher consumpion. Subsequen simulaions show, however, ha he subsidy-ineracion effec can be imporan when he relaive polluion inensiy differs significanly beween he ax-favored and non-axfavored producion secors. MC S indicaes marginal cos under he polluion ax wih boh labor axes bu wih no revenue-recycling effec; ha is, environmenal ax revenues are neuralized by adjusing he lump-sum ransfer. The difference beween his curve and MC SI reflecs he (marginal) axineracion effec. Thus he ax-ineracion effec causes a subsanial upward shif of he marginal cos curve (see Goulder e al. (997) for more discussion). 28 For his case he subsidy is financed by a (negaive) lump-sum ransfer, and he lump-sum ransfer is adjused o neuralize he revenue effecs of environmenal policies. 6

20 Parry and Beno RFF MC COM shows marginal coss under he polluion ax wih revenues used o reduce he comprehensive ax (holding governmen ransfers consan in real erms). I equals MC S less he (marginal) benefi from he normal revenue-recycling effec. Comparing MC COM wih MC SI we can infer ha he ax-ineracion effec dominaes he normal revenue-recycling effec a he margin (excep a zero polluion reducion). Again, his resul is familiar from oher sudies (e.g. Goulder e al., 997). The gap beween MC S and MC COM decreases wih he amoun of polluion reducion, since he erosion of he polluion ax base reduces he marginal revenue-recycling effec. Indeed he marginal revenue-recycling effec evenually becomes negaive if polluion is reduced by more han a cerain amoun. Beyond his poin he polluion ax affer curve is downward sloping and MC COM rises above MC S. Finally, MC C is he marginal cos curve for he polluion ax wih revenues used o reduce he non-comprehensive labor ax. 29 This curve equals MC S less he (marginal) benefi from he srong revenue-recycling effec. I has a negaive inercep and marginal coss are negaive up o a polluion reducion of 5 percen in our medium cos scenario. Thus, even if here were no environmenal benefis i would sill be opimal o reduce polluion by 5 percen in his case. Up o a poin herefore, he environmenal ax swap reduces he overall coss of he ax sysem, no couning environmenal benefis. I makes he ax sysem more efficien by effecively reducing he ne subsidy for ax-favored consumpion. 30 On he oher hand, he environmenal ax is more disorionary han he labor ax in he sense ha i excludes non-polluing inpus from he ax base. A leas for more modes levels of polluion ax, he advanage from he former effec ouweighs he disadvanage from he laer effec. B. Toal Coss Figure 3 shows he oal (as opposed o marginal) coss of reducing polluion under various policies, expressed relaive o he oal primary coss. When a cos curve lies above (below) uniy, he ne impac of he ax sysem is o raise (lower) he overall cos of a policy above (below) is primary coss. The mos novel feaure of Figure 3 is he oal cos curves for he polluion ax wih revenues used o reduce he non-comprehensive labor ax, denoed TC C, which are shown for he low, medium and high MEB scenarios. These curves lie below he horizonal axis for polluion reducions up o beween 7 and 42 percen. When oal coss are negaive he welfare gain from reducing he coss of he ax sysem more han offse he primary cos of he policy. Goulder (995a) refers o his as a "srong" double dividend from environmenal axes. When oal coss are posiive bu less han uniy, here is sill a ne welfare gain from ineracions wih he ax sysem. This is referred o as an "inermediae" form of he double 29 To avoid cluering Figure 2, we omi marginal coss for emissions permis in he presence of pre-exising axes. The effecs of his policy are explained below. 30 If he were no ax deducions in our model (and no environmenal effecs), he labor ax would always be more efficien han he polluion ax for raising revenues. 7