Evaluating tax reforms in the presence of externalities

According to the double-dividend hypothesis, revenue-neutral green tax reforms are expected both to improve the quality of the environment and to reduce the existing tax distortions. This paper develops welfare measures which are used to estimate these dividends separately. It is shown that the existing tax system and the choice of the tax rate cuts which accompany an increase in green taxes have considerable impact on the magnitude of the environmental dividend. Even a negative impact cannot be ruled out. Furthermore, the welfare measures allow us to analyse the trade-off between the two dividends and to identify welfare-improving tax reforms. 'We shall deal with our economic system as it is and as it may be modified, not as it might be if we had a clean sheet of paper to write upon; and step by step we shall make it what it should be. ' Woodrow Wilson 1