Environmental Taxation, Inequality and Engel’s Law: The Double Dividend of Redistribution

Abstract

Empirical evidence shows that low-income households spend a high share of their income on pollution-intensive goods. This fuels the concern that an environmental tax reform could be regressive. We employ a framework which accounts for the distributional effect of environmental taxes and the recycling of the revenues on both households and firms to quantify changes in the optimal tax structure and the equity impacts of an environmental tax reform. We characterize when an optimal environmental tax reform does not increase inequality, even if the tax system before the reform is optimal from a non-environmental point of view. If the tax system before the reform is calibrated to stylized data—and is thus non-optimal—we find that there is a large scope for inequality reduction, even if the government is restricted in its recycling options.

Appendix: First-Order Conditions of Households and Firms

Households

By combining the households’ first-order conditions with their budget equation, the following explicit demand functions can be derived:

$$\begin{aligned} C_i= & {} \frac{\alpha }{p_C(\alpha +\beta +\gamma )}H(w,p_D,\tau _{w,i},L), \end{aligned}$$

(17)

$$\begin{aligned} D_i= & {} \frac{\beta }{p_D(\alpha +\beta +\gamma )}H(w,p_D,\tau _{w,i},L)+D_0 \end{aligned}$$

(18)

$$\begin{aligned} l_i= & {} \frac{\gamma }{(\alpha +\beta +\gamma )(1-\tau _{w,i})\phi _i w}H(w,p_D,\tau _{w,i},L), \end{aligned}$$

(19)

with

$$\begin{aligned} H(w,p_D,\tau _{w,i},L) = ( (1-\tau _{w,i})\phi _i w T + L - p_D D_0). \end{aligned}$$

(20)

Firms Maximizing profits of both firms yields four first-order conditions:

$$\begin{aligned} w= & {} \frac{\partial F_j(T_j,Z_j)}{\partial T_j}=\epsilon _j T_j^{(r-1)} F_j^{(1-r)} p_j, \end{aligned}$$

(21)

$$\begin{aligned} \tau _Z= & {} \frac{\partial F_C(T_C,Z_C)}{\partial Z_C}=(1-\epsilon _j) Z_j^{(r-1)} F_j^{(1-r)} p_j, \end{aligned}$$

(22)

with $j \in \{C,D\}$.