Pigovian Tax - Double Dividend Hypothesis

Double Dividend Hypothesis

In 1998, Don Fullerton and Gilbert E. Metcalf evaluated the double dividend hypothesis in “Environmental Taxes and the Double-Dividend Hypothesis: Did You Really Expect Something for Nothing?”. This article defines the double-dividend hypothesis as the theory that environmental taxes can improve the environment and increase economic efficiency simultaneously. Either motivation can legitimately support a tax reform. The first dividend intuitively makes sense: decreasing pollutant emissions improves the environment. The improvement in economic efficiency results from a shift away from distorting taxes such as the income tax. Fullerton and Metcalf note that for every $1 extracted in taxes, a $1.35 burden falls on the economy. In a sense, the private sector must swallow a 35 cent excess burden for no particular reason. The second dividend aims to eliminate some of this excess burden.

Tempting as it may be to try, Fullerton and Metcalf argue, the validity of the double-dividend theory cannot be established as a whole. An observer must evaluate each circumstance individually. Fullerton and Metcalf do provide guidelines for this analysis. Two questions help shape this analysis: what is the status quo? What are the specifics of the reform? The amount and nature of the current taxes, permits, and regulations greatly influence the results of the additional tax. Also, where the tax revenue goes greatly affects the success of the tax.

Secondly, Fullerton and Metcalf say the previous literature on Pigouvian taxes focused too heavily on the revenue dividend and too lightly on the environmental dividend of environmental taxes. His predecessors naively value revenue too much, Fullerton and Metcalf argue, because they fail to recognize that all taxes impose costs on someone. These taxes could outweigh the environmental benefit. Thus, the government must use the Pigouvian tax revenue to lower another tax if it wants to minimize the economic damage of a tax.

Fullerton and Metcalf also mention that the effectiveness of any sort of Pigouvian tax depends on whether it supplements or replaces an existing pollution regulation. If the tax replaces a pollution regulation, it will most likely be environmentally neutral, even if it is revenue-positive. If it supplements the regulation, it may or may not be environmentally and revenue-neutral, depending on the effectiveness of the original regulation. The status quo substantially affects the outcome of a proposed tax.