Environmental taxes and quotas in the presence of distorting taxes in factor markets

Environmental quotas tend to compound the welfare cost of pre-existing tax distortions in the labor market. Under plausible parameters, this source of welfare loss can easily be large enough to outweigh the entire partial equilibrium welfare gain from the quota. Environmental taxes induce the same interaction effect, however they also raise government revenues. If the revenues are used to reduce distortionary taxes, then most of this interaction effect can be offset. Therefore, revenue-raising can be a necessary condition for environmental policies to increase welfare.