Question

If the tax interaction effect dominates and all we get is the first dividend, does this mean there is no point to using the revenues to reduce labor taxes and it is best to spend the money on

something else? Explain.

Answer 1

We know that the environmental taxes discourage economic activity it is because they will increase the cost of producing output. This will reduce the overall employment in the economy. This will create a distortion in the labour and capital market. This economic cost is called tax interaction effect. The tax interaction effect dominates the tax recycling effect. So the tax creates economic cost on the basis of both household and firms are consumed and produced less and they transferred their consumption and production to other non-tax activities.