Nonseparable utility and the double dividend debate: Reconsidering the tax-interaction effect

The literature on the use of environmental taxes in the presence of distortionary (labor) taxes warns that a partial-equilibrium Pigouvian tax analysis is not appropriate because increasing the price of dirty goods can futher aggravate the prexisting distortions. This argument is most frequently made assuming that labor is taxed to meet a fixed revenue requirement. When a dirty good is also taxed, others argue that this lowers workers' real wages, causing people to reduce their labor supply below its already suboptimal level, aggravating labor market distortions. However, most papers ignore the effect that a cleaner environment can have on labor supply. That is, most past work has assumed that the quality of the environment is weakly separable in the utility function. We argue that a cleaner environment can increase labor supply, at least partially offsetting any incentive for workers to decrease their labor supply. Further, we show explicitly how relaxing the separability assumption affects the standard results.