Tax Policy towards Energy and the Environment

Metcalf, Gilbert E., NBER Reporter

My research over the past several years has focused on the role of taxes and other instruments in environmental and energy policy. I have focused mainly on instrument design issues in a general equilibrium framework, as well as on the distributional implications of energy and environmental taxation.

Environmental Policy

An influential paper by Bovenberg and deMooij touched off a large research agenda on the optimal design of environmental taxes in a second-best world with pre-existing taxes. (1) It had long been understood that taxes on pollution could help to internalize pollution externalities. Beginning in the 1980s, analysts began to argue that the revenue from pollution taxes could be used to reduce other distortionary taxes, thereby generating a second "dividend" with a pollution tax. Some analysts concluded that the existence of this second dividend argued for a higher tax on pollution than the first-best Pigouvian prescription, where the tax is set equal to the social marginal damages of pollution.

Bovenberg and deMooij showed that for reasonable consumer preferences the optimal tax would, in fact, be lower than social marginal damages. Their insight was that while an environmental tax would enhance efficiency by discouraging pollution, it was still a distortionary tax and could interact with other distortionary taxes with first-best efficiency losses. Building on this initial result, researchers began to identify the gains from raising revenue via environmental policy instruments (pollution taxes or auction revenues from cap and trade systems). With Don Fullerton, I showed that the popularly held view that revenue-raising instruments were preferred to non-revenue-raising instruments focused on the wrong point. (2) What mattered was whether policies created scarcity rents and whether the government received the rents and used them to lower other distortionary taxes.

The result--that the second-best tax on pollution was below social marginal damages--was troubling to many environmentalists who were concerned that it implied that in a world with distortionary taxation more pollution should be allowed. Such a conclusion confuses price and quantity effects. That a first-best price rule ("set pollution taxes equal to social marginal damages") is modified in the presence of tax distortions ("set pollution taxes below social marginal damages") does not imply …

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Publication information: Article title: Tax Policy towards Energy and the Environment. Contributors: Metcalf, Gilbert E. - Author. Journal title: NBER Reporter. Publication date: Winter 2006. Page number: 16+. © 1999 National Bureau of Economic Research, Inc. COPYRIGHT 2006 Gale Group.

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