Ricardian rents, environmental policy and the 'double-dividend' hypothesis

Recent studies on the so-called double dividend hypothesis find that environmental tax swaps exacerbate the costs of the tax system and therefore do not produce a double dividend. We extend these models by incorporating a fixed-factor in the production of the polluting good and, therefore, allowing Ricardian rents to be generated in the economy. In this setting, an environmental tax reform with revenues used to cut pre-existing labor taxes can produce a double dividend. Moreover, the overall costs of environmental tax swaps are negative up to I I percent of emissions reductions, suggesting the potential for a strong double dividend and confirming that environmental taxes should be part of the optimal tax system. (c) 2006 Elsevier Inc. All rights reserved.