Money Illusion and the Double Dividend in the Short Run

In their seminal paper, Bovenberg and De Mooij (1994) elucidate why an ecological tax reform will not yield a double dividend, i.e. fails to increase the efficiency of the tax system. The present paper slightly modifies the Bovenberg and De Mooij model by introducing money illusion. With this modification, an environmental tax reform that raises the price level may generate a double dividend, since the additional tax on the dirty good does not reduce labor supply. A prerequisite for the double dividend to occur is a sufficiently small elasticity of substitution between clean and dirty consumption. Moreover, accounting for money illusion always reduces the intertemporal gross cost of the tax reform.