The Welfare Consequences of Carbon Tax Reform in Open Economies: The Application of Computable General Equilibrium Model for Pennsylvania

ABSTRACTSTaxes on environmental externalities have long been recognized in the economics literature as a cost-effective mechanism for reducing the costs of environmental degradation. However, in recent years there has been substantial interest in other possible benefits from environmental taxes, most notably, the economic gains that could result from substituting revenues from environmental taxes for conventional, distortionary taxes on labor income or other goods and services. Emerging from this literature is the ¡°double dividend hypothesis¡± that the economic gains from environmental taxes will be greater if the revenues are used to reduce distortionary taxes rather than be returned to consumers through lump sum transfers.Most theoretical and empirical research on the double dividend has been conducted under the assumption of a closed economy. This assumption removes the possibly important effects of interregional factor mobility and interregional trade. Moreover it is an unrealistic assumption for most economies, and especially for those of small countries or sub-national political jurisdictions, such as states.The purpose of this study is to investigate the double dividend hypothesis in the context of an open economy. The study specifically considers the hypothesis in the context of a carbon tax in the state of Pennsylvania. To test the double dividend, the carbon tax revenues are used to reduce labor income taxes in the state. A static CGE model is constructed for Pennsylvania. The model captures key features of a regional open economy, most notably endogenous factor mobility, and interregional trade. An innovative feature of the model is labor migration in response to environmental quality and the after-tax wage rate.Results show that the double dividend holds for the Pennsylvania model for a carbon tax imposed either unilaterally by the state government, but also for a national carbon tax. The magnitude of the double dividend is larger for the state tax than for the federal tax. Labor migration affects negatively the double dividend, but the impact is small.