Environmental taxation and employment

DE ECONOMIST 143, NO. 2, 1995 ENVIRONMENTAL TAXATION AND EMPLOYMENT BY A. LANS BOVENBERG* 1 INTRODUCTION In recent years, policymakers have shown an increasing interest in shifting the tax structure away from labor income towards pollution, with the dual objective to reduce environmental damage and increase employment. In particular, by using the revenues from environmental taxes to cut taxes on labor, governments may be able to reap a double dividend - not only a cleaner environment but also a higher level of employment (see, e.g., Pearce (1991), Oates (1991), and Repetto et al. (1992)). This paper explores in some detail the impact on employment of an environmental tax reform - i.e. increasing pollution taxes - and using the revenues to reduce distortionary taxes. In doing so, the paper focuses on the second dividend, i.e. the employment impact. The effects on the environmental objectives of the government are discussed only if the environmental consequences of a tax reform generate important feedback effects on employment. By abstracting from the ecological benefits associated with an environmental tax reform, the paper does not provide a complete picture of the welfare effects. Indeed, even if such a reform harms employment, overall welfare may still rise if the ecological benefits offset the costs associated with lower employment. The paper does not distinguish between, on the one hand, pollution taxes targeted at cutting pollution and, on the other hand, green taxes primarily aimed at raising public revenues. Indeed, the terms environmental taxes, green taxes, and pollution taxes are used interchangeably. Any environmental tax h/is effects on both environmental quality and public revenues. However, while it discusses environmental taxes in general, the paper focuses in particular on taxes on fossil fuels. The reason is that, within the class of environmental levies, these taxes exert the largest macroeconomic impact. In particular, they can yield significant amounts of tax revenue. * CentER for Economic Research, Tilburg University, EO. Box 90153, 5000 LE Tilburg, The Netherlands, phone: (+31) 13 662770. The author would like to thank the OECD for financial support and Sijbren Cnossen for insightful comments on an earlier draft. De Economist 143, 111-140, 1995. 9 1995 Kluwer Academic Publishers. Printed in the Netherlands. 112 A.L. BOVENBERG An important assumption underlying the analysis is that lowering the tax burden on labor is an effective instrument to raise employment. 1 A lower tax burden on labor generally raises the income from work to the employee and reduces labor costs for the employer. The incidence of the tax cut, i.e. whether the lower tax burden is reflected primarily in lower wage costs per unit of output or higher after-tax wages depends on supply and demand elasticities and on various labor market institutions. In any case, a lower tax burden on labor is likely to stimulate the demand for labor by reducing labor costs. At the same time, by raising the after-tax wage, a lower tax burden boosts labor supply if the uncompensated wage elasticity is positive. This paper assumes that this elasticity is indeed positive. 2 In order to explore the employment effect of tax policy, this paper examines the impact of taxes on after-tax wages and labor costs. In particular, taxes are said to be borne by labor if, given the level of wage costs per unit of output, they reduce the level of real after-tax wages. Accordingly, the paper analyzes not only labor-related charges to employers (e.g., payroll taxes) but also other taxes that reduce after-tax wage income, such as personal income taxes. Taxes on consumption are relevant as well because they reduce the real value of a given level of the nominal wage. Even taxes on other inputs, such as capital, may reduce after-tax wages through general equilibrium effects. In particular, if these taxes discourage capital accumulation, they reduce labor productivity and hence beforetax wages. In this way, the ultimate burden of capital taxes falls on labor income so that these taxes amount to implicit taxes on labor. In taking a macroeconomic perspective, this paper explores how taxes affect after-tax wages in general equilibrium. Hence, the tax burden measure adopted in this paper includes not only labor taxes explicitly paid by workers but also 'implicit' taxes on labor. These latter taxes are collected elsewhere in the economy but are ultimately paid for by labor in terms of lower real after-tax wages. For an environmental tax reform to benefit employment by reducing the tax burden on labor, two conditions must be met. First, the overall tax level should be contained. Second, the distribution of the tax burden should be moved away from workers to others, i.e. capital owners, the owners of resources, and the recipients of income transfers. Only if these two conditions are met, do workers face a lower tax burden. Section 2 deals with the first condition. It explains that environmental taxes typically raise the overall burden of taxation on private incomes - even if the revenues are used to reduce other distortionary taxes rather than to raise public spending. The basic reason is that pollution taxes reduce 'subsidies' provided to 1 For empirical studies on the impact of taxation on employment, see e.g., Bean, Layard, and Nickell (1986), and Coe (1990). 2 Most empirical studies indicate that the supply elasticity of married men is close to zero. However, the uncompensated supply elasticity for women is typically found to be significantly positive. As workers get more scope to select their own working hours, the labor supply elasticity is likely to rise. ENVIRONMENTALTAXATIONAND EMPLOYMENT 113 the private sector in the form of underpriced pollution. In this way, environmental taxes cause the private sector to supply the public good of a cleaner environment. The associated additional abatement costs (or, in an alternative terminology, the lower subsidies to pollution) raise the overall tax burden as measured by the loss in private income due to government intervention. This measure for the tax burden is distinct from total tax revenues collected because it also includes 'implicit' or 'hidden' taxes and subsidies due to government regulations. In particular, it incorporates the 'excess burden' of taxation, i.e. the costs of taxation in excess of the revenues collected. Furthermore, it includes 'implicit' subsidies to pollution in the form of prices for pollution below social damage. Section 3 compares the effects of alternative instruments of environmental policy that yield the same level of environmental quality. To protect employment, environmental policy should contain the overall tax burden. Hence, this section discusses the cost effectiveness of the instruments and it explores whether, in the presence of high distortionary taxes, instruments that generate public revenues are particularly attractive. The sec (...truncated)