Environmental Taxes and Pre-Existing Distortions: The Normalization Trap

The double-dividend hypothesis claims that green taxes will both improve the environment and reduce the distortions of existing taxes. According to the earlier literature on the double dividend the tax rate for polluting goods should be higher than the Pigovian tax which fully internalizes the marginal social damage from pollution, in order to obtain a 'second dividend'. On the contrary, Bovenberg and de Mooij (1994) argue that environmental taxes typically exacerbate, rather than alleviate, pre-existing distortions. The optimal pollution tax should therefore lie below the Pigovian tax. This paper points out that there is no real contradiction between these apparently opposing policy recommendations. It will be shown that the difference in the results appears because, implicitly, different definitions of the second-best optimal pollution tax are chosen.