Grantee Research Project Results
Final Report: The Economics of Environmental Taxes: Using First-Best Models in a Second-Best World
EPA Grant Number: R829582Title: The Economics of Environmental Taxes: Using First-Best Models in a Second-Best World
Investigators: Howarth, Richard B.
Institution: Dartmouth College
EPA Project Officer: Hahn, Intaek
Project Period: January 1, 2002 through December 31, 2003
Project Amount: $67,887
RFA: Market Mechanisms and Incentives for Environmental Management (2001) RFA Text | Recipients Lists
Research Category: Environmental Justice
Objective:
Economists have emphasized the potential use of greenhouse gas emissions taxes as a tool for addressing the social costs of climate change. In gauging the potential impacts of such taxes on the U.S. and world economies, analysts often use first-best models of the interaction between public policies and the market decisions of households and firms. First-best models abstract away from the economic impacts of pre-existing taxes, equating the marginal costs and benefits of emissions abatement to achieve economic efficiency. During the last decade, theoretical and empirical research has established that environmental taxes interact with existing taxes on income and returns to capital in a manner that has direct implications for environmental policy. The common wisdom holds that first-best models may overstate optimal greenhouse gas taxes and emissions control rates. The objective of the research project was to explore this question by examining the links between a simplified first-best model and a more realistic second-best model in which distortionary taxes impair economic efficiency.
Summary/Accomplishments (Outputs/Outcomes):
Methods
The models developed in this project were based upon a set of widely accepted stylized facts concerning observed trends in the world economy, the impacts of taxation, and the costs and benefits of greenhouse gas emissions abatement. These stylized facts were used to calibrate a simple one-sector model of the global economy in two related specifications.
In the first-best specification, the impacts of pre-existing taxes and government expenditures were ignored and the equilibrium path of the economy was modeled based on the decisions of utility-maximizing households and profit-maximizing firms. As is common in the economics of climate change, household behavior was modeled based on the assumption that households aim to maximize the discounted value of utility over an infinite time horizon. Businesses were assumed to maximize a Cobb-Douglas production function in which greenhouse gas emissions were generated as a by-product. The costs of climate change were represented as an amenity externality that directly reduces household welfare. The costs of emissions abatement were represented in terms of reductions in total factor productivity.
In the second specification, the impacts of pre-existing taxes and government expenditures were explicitly included in the model based on actual conditions in the world economy. Because the model does not distinguish between world regions, the tax rates and public spending levels incorporated in the analysis do not precisely represent those currently prevailing in any one country. The simplicity of the analysis, however, is useful in highlighting the insights that arise when first-best models are generalized in a realistic way to account for the role of government in real-world economic systems. Aside from the influence of taxation, the two specifications were identical in all relevant respects.
Results
In the first-best specification, the optimal greenhouse gas emissions tax rises from $25 per metric ton of carbon equivalent in the present to $183 dollars per metric ton in 2100. In this specification, the first-best tax is set equal to the discounted marginal benefits that short-term emissions abatement confers on the future economy.
In the more realistic specification that accounts for the influence of pre-existing taxes, the optimal emissions tax rises from $84 to $280 per metric ton over the course of the next century. This outcome arises in the case where the revenues raised by the emissions tax are used to provide targeted cuts in labor and capital tax rates. Detailed analysis of this case suggests that using emissions tax revenues to reduce long-run returns to capital investment yields particularly large welfare gains. Smaller net benefits arise when emissions tax revenues are used to cut labor taxes, and returning emissions tax revenues to households in the form of lump-sum transfers is particularly inefficient.
Interestingly, these results appear to be driven by the interplay between capital taxation and the pure rate of time preference (i.e., households’ willingness to sacrifice present welfare to obtain long-run environmental benefits). In first-best models, the rate of time preference is calibrated based on the marginal productivity of private capital as measured by the (pre-tax) rate of return in the overall economy. In the presence of capital taxes, however, economic theory suggests that the pure rate of time preference should be calibrated based on the after-tax rate of return. A comparison of the two specifications found that abstracting away from the influence of pre-existing taxes can lead analysts to understate the present-value net benefits of greenhouse gas emissions by as much as 87 percent given realistic empirical assumptions. This so-called calibration bias in turn leads first-best models to understate optimal greenhouse gas emission taxes.
The foregoing results are based on the assumption that household preferences are fixed and independent of prevailing economic conditions. In previous work, the principal investigatorfound that relative consumption effects play an important role in real-world household behavior (Brekke and Howarth, 2002). When relative consumption effects are incorporated in the model developed in this project, optimal greenhouse gas emissions taxes are on average 92 percent higher than those prescribed by the first-best specification and 65 percent higher than those that arise when pre-existing taxes are considered but relative consumption effects are ignored. These results provide a further indication that simplified first-best methods can lead to the underestimation of optimal greenhouse gas emissions taxes.
Conclusions:
The main findings of this research project are as follows:
- Ignoring the influence of pre-existing taxes and government expenditure may lead analysts to substantially underestimate optimal greenhouse gas emissions taxes.
- Properly coordinating environmental taxes with the overall tax system can significantly improve the efficiency of taxation, partially offsetting the direct costs of emissions abatement.
- Abstracting away from pre-existing taxes can lead analysts to overstate the pure rate of time preference and hence understate the present-value benefits of future environmental quality.
In contrast with much of the existing literature, this project has explored these issues in the context of an intertemporal economy. This approach highlights the substantial economic benefits that arise when greenhouse gas emissions tax revenues are used to cut distortionary taxes on returns to capital investment. In the long run, capital tax revenue recycling yields greater benefits than those that arise when emissions tax revenues are used to reduce labor taxes.
Journal Articles on this Report : 2 Displayed | Download in RIS Format
Other project views: | All 11 publications | 4 publications in selected types | All 2 journal articles |
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Howarth RB. Calibration bias in the analysis of environmental taxes. American Journal of Agricultural Economics 2004;86(3):813-818. |
R829582 (Final) |
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Howarth RB. The present value criterion and environmental taxation: the suboptimality of first-best decision rules. Land Economics 2005;81(3):321-336. |
R829582 (Final) |
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Supplemental Keywords:
global climate, public policy, market mechanisms and incentives, distortionary taxation, market mechanisms, climate change, global climate change, economic models, ecosystem sustainability, environmental economics, environmental taxation, first-best models, green house gas taxes, pollution fees,, RFA, Scientific Discipline, Economic, Social, & Behavioral Science Research Program, Air, Ecology, Chemistry, climate change, Social Science, Market mechanisms, effects of policy instruments, financial mechanisms, policy instruments, environmental monitoring, impact of federal policy instruments, policy making, government intervention, economic models, environmental taxation, environmental impact fees, pollution fees, green house gas taxes, cost effective, tax interactions, first-best models, ecosystem sustainability, global warming, environmental economicsProgress and Final Reports:
Original AbstractThe perspectives, information and conclusions conveyed in research project abstracts, progress reports, final reports, journal abstracts and journal publications convey the viewpoints of the principal investigator and may not represent the views and policies of ORD and EPA. Conclusions drawn by the principal investigators have not been reviewed by the Agency.