Climate Change 2001:
Working Group III: Mitigation
Other reports in this collection Double Dividend

The potential for a double dividend arising from climate mitigation policies has been extensively studied during the 1990s. In addition to the primary aim of improving the environment (the first dividend), such policies, if conducted through revenue-raising instruments such as carbon taxes or auctioned emission permits, yield a second dividend, which can be set against the gross costs of these policies.

The literature demonstrates theoretically that the costs of addressing greenhouse targets with policy instruments of all kinds–command-and-control as well as market-based approaches–can be greater than otherwise anticipated, because of the interaction of these policy instruments with existing domestic tax systems.8 Domestic taxes on labour and investment income change the economic returns to labour and capital and distort the efficient use of these resources.

The cost-increasing interaction reflects the impact that GHG policies can have on the functioning of labour and capital markets through their effects on real wages and the real return to capital.9 By restricting the allowable GHG emissions, permits, regulations, or a carbon tax raise the costs of production and the prices of output, and thus reduce the real return to labour and capital. If government revenues are to remain unchanged, labour or capital tax rates have to be raised, exacerbating prior distortions in the labour and capital markets. Thus, to attain a given GHG emissions target, all instruments have a cost-increasing “interaction effect”.

For policies that raise revenue for the government (carbon taxes and auctioned permits), this is only part of the story, however. These revenues can be recycled to reduce existing distortionary taxes. Thus, to attain a given GHG emissions target, revenue-generating policy instruments have the advantage of a potential cost-reducing “revenue-recycling effect”, as compared to the alternative, non-auctioned tradable permits or other instruments that do not generate revenue (Bohm, 1998). In a simple, stylized representation of the economy, Bovenberg et al. (1994) and Goulder (1995a, b) suggest that in only a few cases is the tax interaction effect fully offset by the revenue-recycling effect. In theoretical, numerical analyses, the “interaction effect” is found to be larger than the “revenue-recycling effect” (Parry et al., 1999), which means that the introduction of an environmental policy, regardless of the policy instrument(s) used, has a net cost to the economy.10 It is also true, however, that under some circumstances the (cost-reducing) “revenue-recycling effect” might exceed the (cost-increasing) “interaction effect”. This could happen if, for example, the interaction effect was small, for example because of a sufficiently inelastic labour supply, or if some highly distortionary pre-existing taxes could be lowered.11

However, it is unclear whether the empirical findings of the interaction effect are due more to the assumptions invoked for tractable general equilibrium analysis than to real-world considerations (Kahn and Farmer, 1999).

In summary, all domestic GHG policies have an indirect economic cost from the interactions of the policy instruments with the fiscal system, but in the case of revenue-raising policies this cost is partly offset (or more than offset) if, for example, the revenue is used to reduce existing distortionary taxes. Whether these revenue-raising policies can reduce distortions in practice depends on whether revenues can be “recycled” to tax reduction. See Chapter 6 for the policy relevance of these estimated effects and Chapter 8 for model-based empirical studies.

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