The Feasibility of the Double‐Dividend Hypothesis in a Democratic Economy

• Author: Yu‐Bong Lai
• DOI: http://doi.org/10.1111/sjoe.12213
• Published date: 01 January 2018
• Date: 01 January 2018

©The editors of The Scandinavian Journal of Economics 2016.

Scand. J. of Economics 120(1), 211–241, 2018

DOI: 10.1111/sjoe.12213

The Feasibility of the Double-Dividend

Hypothesis in a Democratic Economy*

Yu-Bong Lai

National Chengchi University, Taipei 11605, Taiwan, Republic of China

yblai@nccu.edu.tw

Abstract

The two dividends in the double-dividend hypothesis are assumed to be independent.

This assumption can be misleading when it comes to formulating policy. I construct a

model where the pollution tax rate is voted for by heterogeneous people. In addition to

the revenue-recycling effect, the equilibrium pollution tax rate depends on two opposite

forces: the tax-cutting effect and the profit effect. The two forces show that an instrument

that exploits a greater revenue-recycling effect can cause a more severe environmental

deterioration, thereby resulting in the infeasibility of the hypothesis. The introduction of

the interdependence between the two dividends can also mean that non-revenue-raising

instruments are more efficient than revenue-raising instruments.

Keywords: Environmental policy; green tax reform; income inequality; political economy

JEL classification:D72; Q52; Q58

I. Introduction

Environmental policy instruments that can raise tax revenues have

been receiving much support. The reasoning for this is not hard to

understand. Revenues from revenue-raising (RR) instruments can be used

to cut existing distortionary taxes, such as labor taxes, and thus the

overall excess burden of the tax system is reduced. This is known as the

revenue-recycling effect.1In other words, RR instruments can generate

two benefits: environmental protection, and the welfare enhancement that

arises from cutting distortionary taxes. This is the main assertion of the

double-dividend hypothesis.

*The author is grateful to two anonymous referees for their valuable comments and suggestions.

The remaining errors are the author’ssole responsibility. Financial support from the Ministry of

Science and Technology (Grant 104-2410-H-004-006-MY2) is also gratefully acknowledged.

1As indicated by Goulder et al. (1997), the distinction between the revenue-recyclingeffect and

revenue raising is essential. Revenue-recycling refers to the use of environmental tax revenues

to reduce other distortionary taxes, rather than distributing the tax revenues in a lump-sum

manner. In this paper, RR instruments are instruments that can generate a revenue-recycling

effect.

212 Feasibility of the double-dividend hypothesis

When demonstrating the double-dividend hypothesis, most of the

literature implicitly assumes that the stringency of environmental regulation

is independent of the way that pollution tax revenues are used. In practice,

however, the two dividends are closely related (Sterner, 2003). Then there

arises the following question. What is the relationship between the two

dividends? In this paper, I aim to address this question. In other words,

I do not treat the two dividends in the hypothesis as fixed; instead, I

establish an interdependence between them.

The answer to the above question is important in two respects. First,

there is the infeasibility of the double-dividend hypothesis. If the two

dividends are in conflict with each other, then the hypothesis literally

fails. Although a number of papers have pointed out the infeasibility of

the hypothesis, their infeasibility refers to the augmented distortion of

existing taxes caused by the pollution tax rate, rather than the trade-off

between the two dividends.

Second, there is the relative efficiency of policy instruments. As pointed

out, given the stringency of environmental protection, the double-dividend

hypothesis claims that RR instruments are more efficient than non-revenue-

raising (NRR) instruments. Once the interdependence between the

dividends is introduced, I show that the opposite result can occur. This

indicates that, regardless of whether the interdependence between the two

dividends is introduced or not, different policy implications can arise.

To demonstrate these points, I consider a democratic economy, where

people vote for the pollution tax rate. I set up a voting model because

determining environmental policies through referenda is common around

the world, and thus it appears necessary to investigate policy formation

from the perspective of political economy. The model contains individuals

who are endowed with different levels of labor productivity. The decisive

voter is the one with the median productivity. By contrast, the optimal

pollution tax rate that maximizes social welfare reflects the ideal tax rate of

the individual with average productivity. Because the median productivity

is assumed to be below the average productivity, the difference in the

endowment between the median voter and the average individual generates

two effects, leading the equilibrium pollution tax rate to be higher or lower

than the optimal level.2

This model contains a clean-goods sector and a polluting-goods sector.

Individuals provide labor to the two sectors as the input. The labor income

2As pointed out by Bovenberg(1999), distributional considerations can prevent the government

from adopting the efficient policy. He further argues that “distributional issues are at the heart

of the double-dividend issue” (Bovenberg, 1999, p. 433). This paper’s approach corresponds

to his claim.

©The editors of The Scandinavian Journal of Economics 2016.