INSTITUTE OF MATHEMATICAL ECONOMICS

Thorsten Bayindir-Upmann

Working-Paper No. 259

July 1996

Abstract

The implications of an ecological tax reform are not yet well investigated when firms do not behave competitively and the provision level of public services is not exogenously fixed.
To fill this gap, we present a model encompassing a monopolistic firm and endogenous provision of public services:
At some initial state the firm faces only a capital tax, but a proposed tax reform calls for the imposition of a second tax -- an emission tax. We derive the optimal (second-best) tax formulae of the initial and the reformed tax system, providing some insight into those variables that determine governmental behavior: Under the initial tax system, the tax rate on capital decreases as the government puts more weight to ecological problems, whereas the reformed capital tax is independent of the environmental damage.

Since we deal with a drastic rather than with a marginal tax reform, a comparison of the initial and the reformed tax rates is difficult. Yet, numerical calculations suggest that the government does not only establish a positive emission tax but also increases the tax rate on capital, implying that both tax rates, public revenue, and the environmental quality are initially too low. Moreover, although profit and consumer surplus fall, the ecological tax reform implies significant, and possibly huge, welfare gains, which are accompanied by substantial improvements of the environmental quality. Hence, this paper rather rejects than supports the occurrence of a `double dividend'; yet, it shows that the existence of real costs of an ecological tax reform may not be abused as an argument to hinder its enforcement.

Keywords: ecological tax reform, pollutant emissions, monopoly taxation, second-best analysis, optimal taxation