Labor supply and the double-dividend

Abstract

A series of recent articles have argued that environmental taxes and cap-and-trade permit systems generate large distortions in the labor market. The claim is made that the higher prices for dirty goods induced by these incentive-based systems generate a ‘tax interaction effect’ leading to reductions in labor supply that are generally, on net, welfare reducing. For this reason, it is argued, a double-dividend seldom exists. However, price level increases, both by lowering family income and by reducing cross-spousal wage substitution effects, will tend to have offsetting positive impacts on labor supply. These effects are large enough to convert negative labor supply responses to rising prices into positive ones. The empirical literature also supports a positive relationship between price level increases and labor supply. These observations cast doubt on a central, critical assumption underlying the critique of the double-dividend in the ‘tax interaction effect’ literature.