On cost benefit rules for green taxes

This paper concerns the welfare effects of a green tax reform in a dynamic general equilibrium model with preexisting taxes on labor income and capital income. In comparison with previous studies on green taxes in dynamic models, which have focused their main attention on long run effects of such reforms, I derive cost benefit rules for a change in the tax mix by using the properties of the value function in optimal control theory. This enables me to relate the welfare effect of a change in the tax mix to responses in employment, the capital stock, (flow) emissions and the stock of pollution along the whole general equilibrium path. Another contribution of the paper is to examine under what conditions an emission tax, which is set permanently below the marginal damage of pollution, is welfare superior to an emission tax path that fully internalizes the external effect.