Environmental Tax Reform and the 'Double Dividend' Hypothesis in a Small Open Economy

In this paper, we build and analyze a general equilibrium model to evaluate the effects of environment tax reform on a small open economy in a &ldquo
suboptimal environment&rdquo
with existing tax distortions. We then use the macroeconomic data from the Chongqing Municipality in China to conduct simulations to empirically test our analytic results. Our main findings include the followings. First, an increase in environmental tax rate can effectively reduce the use of polluting consumer goods by households as well as investment in polluting factors by enterprises. Hence, an increase in environmental tax rate can improve environmental quality and obtain &ldquo
environmental dividend&rdquo
Second, an increase in environmental tax rate can negatively impact employment, family income and economic growth. Hence, there is no &ldquo
non-environmental dividend&rdquo
effect. Third, an increased environmental tax rate has both substitution effect and income effect on household consumption. On the one hand, it motivates households to substitute polluting consumer goods with clean consumer goods. On the other hand, it lowers the total consumption level of households. Fourth, we show that the &ldquo
double dividend&rdquo
hypothesis on environmental tax is invalid. And the optimal environmental tax under the suboptimal environment is lower than the Pigouvian tax rate. Finally, we discuss the policy implications of our results.