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The Economics of Environmental Taxes: Using First-Best Models in a Second-Best World

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Economists have emphasized the potential role of greenhouse gas (GHG) emissions taxes in achieving the goals of the Framework Convention on 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. Such models abstract away from the structure of the existing tax system, equating the marginal costs and benefits of emissions abatement to achieve economic efficiency. In recent years, theoretical research has established that environmental taxes interact with existing taxes on income and returns to capital. The "common wisdom" now holds that first-best models may overstate optimal GHG taxes and emissions control rates. The proposed research will carefully assess this question by exploring the links between a standard first-best model and a related second-best model in which distortionary taxes impair economic efficiency. First-best models choose rates of time preference (or discount rates) based on the pre-tax returns generated by capital investment. Pre-tax returns, however, are substantially higher than the after-tax returns that, in theory, reveal decision-makers' true preferences regarding intertemporal tradeoffs. Hence first-best models both overlook the impacts of existing taxes and discount the future at an excessive rate.

Approach:
The project will revise and recalibrate economic models of climate change and the world economy, comparing the optimal GHG taxes that arise when (a) the existing structure of taxation is omitted from consideration, and (b) the model incorporates realistic assumptions concerning taxes and public expenditure and the response to these policies by market participants.

Expected Results:
Preliminary calculations suggest that first-best models may understate optimal GHG tax rates by as much as 60%. This conclusion, however, is based on simplified assumptions that require further analysis. The project will provide benefits by improving the methods used to evaluate the economic impacts of environmental taxes. Such analysis is of significant importance in discussions of climate change response strategies at the national and international levels.

Supplemental Keywords:
global climate, public policy, market mechanisms and incentives, distortionary taxation. , Air, Economic, Social, & Behavioral Science Research Program, RFA, Scientific Discipline, Chemistry, Ecology, Market mechanisms, Social Science, climate change, Global Climate Change, cost effective, economic models, ecosystem sustainability, effects of policy instruments, environmental economics, environmental impact fees, environmental taxation, financial mechanisms, first-best models, global warming, government intervention, green house gas taxes, impact of federal policy instruments, policy instruments, policy making, pollution fees.

Metadata

EPA/NSF ID:
R829582
Principal Investigators:
Howarth, Richard B.
Technical Liaison:
Research Organization:
Dartmouth College
Funding Agency/Program:
EPA/ORD/Incentives
Grant Year:
2001
Project Period:
January 1, 2002 to December 31, 2003
Cost to Funding Agency:
$67,887
Project Status Reports:
Project Reports:

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