Growth and welfare effects of environmental tax reform and public spending policy

a r t i c l e i n f o This paper considers the implications of environmental tax reform and public spending policy for growth and welfare. Using a two-sector endogenous growth model where the interactions between health, education, and the environment are taken into account, we show that revenue-positive tax reforms combined with a change in the public spending structure may improve long-run growth and welfare. However, this outcome incurs relatively high welfare cost during the transition phase. This is particularly the case when the spending policy favors education spending. Over the recent years, the debate on environmental tax reform has moved on from theoretical discussion to become a practical policy issue in many countries (OECD, 1997, 2010). Several European countries, such as Sweden, Norway, Finland, Denmark, and the Netherlands, implemented environmental tax reforms during the 1990s. More recently, other European countries such as Germany, Italy and the United Kingdom have introduced environmental taxes to reduce their greenhouse gas emissions and raise revenues which may be used in a number way. The public debate on such tax reform is ongoing in other countries, such as France and Switzerland. For any policy discussion it is absolutely critical to know how the environmental tax revenue is recycled. The key issue is to identify the most appropriate policy for achieving two government goals: (1) lower pollution emissions and (2) high economic growth leading to improved social welfare. In this paper we address some question related to environmental tax reforms. How can tax reform be undertaken without reducing growth and social welfare? Do the transitional and long term effects conflict with each other? What are the associated impacts of a change in public spending structures? These questions are central to public debate, not only in countries where environmental tax reform has been introduced, but also in countries where such reform is still under consideration. Recent macroeconomic developments have made progress in analyzing the dynamic effects of taxes, particularly within the framework of endogenous growth models. 1 As a consequence, endogenous growth models have often been used to analyze the effects of environmental taxes on the rate of long-term growth. Ricci (2007) provides a comprehensive survey, which presents various impacts of restrictive environmental policy on growth that have been discussed in the literature. A tighter environmental policy can potentially operate through different mechanisms such as investment, education and R&D. Overall, to generate a …