International Tax and Public Finance, 2:207-219 (1995) 9 1995 Kluwer Academic Publishers The Double Dividend and the Role of Inequality Aversion and Macroeconomic Regimes S. PROOST Center for Economic Studies, Catholic University of Leuven, Naamsestraat 69, 3000 Leuven Belgium D. VAN REGEMORTER Center for Economic Studies, Catholic University of Leuven, Naamsestraat 69, 3000 Leuven Belgium Abstract The introduction of the European Community's carbon-energy tax in a small open economy is analyzed by com- paring two kinds of revenue recycling. We use a dynamic general-equilibrium model with different regimes for the labor market, several income groups, and a crude valuation of environmental benefits. This allows for a more comprehensive empirical test of the double-dividend hypothesis, including equity aspects. It is shown that the weak double-dividend hypothesis can fail when equity aspects are taken into account. Key words: tax reform, general equilibrium, environment, double dividend, climate change 1. Introduction This paper analyzes the introduction of the proposed European Community (EC) carbon- energy tax in the tax and transfer system of a small open economy like Belgium. The Euro- pean energy-carbon tax can be considered to be an international agreement of the minimum national tax type.1 In order to reach the stabilization of emissions promised by the EC in Rio de Janeiro, all EC-member states have agreed to introduce a national carbon tax of a given magnitude in their tax system but may decide themselves on how they will use the extra tax proceeds. The way the countries use these tax proceeds is important and remains at the heart of what has become known as the double-dividend debate (Goulder, 1994). The double- dividend hypothesis states that the introduction of an environmental tax entails gross costs (abatement expenditures and price distortions between energy sources) that can be compen- sated by two types of dividends. The first dividend is the environmental benefit. The second benefit is the efficiency gain that can be made by using the tax revenue to substitute existing distortionary taxes. The strong double-dividend hypothesis claims that this second dividend is even larger than the gross costs--so that the precise knowledge of the environmental benefits is unnecessary in order to justify the environmental tax. Bovenberg (1994) surveys the different theoretical models that can be used to discuss the double-dividend hypothesis and shows that the strong double-dividend hypothesis can occur only under strict and rather unlikely assumptions about the functioning of the economy. This certainly holds for a small open economy.