This paper concerns the welfare effects of a green tax reform in a dynamic
general equilibrium model with preexisting taxes on labor income and capita
l income. In comparison with previous studies on green taxes in dynamic mod
els, which have focused their main attention on long run effects of such re
forms, I derive cost benefit rules for a change in the tax mix by using the
properties of the value function in optimal control theory. This enables m
e to relate the welfare effect of a change in the tax mix to responses in e
mployment, the capital stock, (flow) emissions and the stock of pollution a
long the whole general equilibrium path. Another contribution of the paper
is to examine under what conditions an emission tax, which is set permanent
ly below the marginal damage of pollution, is welfare superior to an emissi
on tax path that fully internalizes the external effect.