Environmental Taxation, Employment and Public Spending in Developing Countries

Environ Resource Econ https://doi.org/10.1007/s10640-018-0230-3 Environmental Taxation, Employment and Public Spending in Developing Countries Karlygash Kuralbayeva1 © The Author(s) 2018. This article is an open access publication Abstract This paper investigates the consequences of environmental tax reforms for unemployment and welfare, in the case of developing countries with a large informal sector, rural–urban migration, and three different assumptions about public spending: (1) as part of a revenue-neutral policy, (2) fixed, and (3) varying endogenously. Under the indexation of unemployment benefits and informal-sector income that give rise to a double dividend, a lower level of public spending is associated with a smaller negative impact on the after-tax income of households and a higher increase in employment. These policies, however, still lead to a reduction in social welfare; even more so in the case of endogenous public spending, although it is associated with a higher increase in employment and a smaller reduction in private-sector incomes. The model implies that complementary policy, in terms of lower public spending, is unlikely to be socially acceptable, and does not support the case for a green tax reforms in developing countries. Keywords Informal sector · Matching frictions · Rural–urban migration · Pollution taxes · Double dividend A previous version of this paper was circulated under the title, Effects of carbon taxes in an economy with large informal sector and rural–urban migration. I thank Alex Bowen, Emmanuel Combet, Baran Doda, Richard Freeman, and Rick van der Ploeg, as well as seminar participants at LSE, the GRI-GGGI Green Growth conference, and the World Congress of Environmental and Resource Economics (Istanbul) for helpful comments and suggestions. I am also grateful to the editor and the referees for thoughtful comments that have significantly improved the paper. I also thank Anna Grodecka and Eileen Tipoe for excellent research assistance. I was employed by the Grantham Research Institute at LSE for much of the project. I acknowledge financial support by the Global Green Growth Institute (GGGI), the Grantham Foundation for the Protection of the Environment, and the UK Economic and Social Research Council (ESRC) through the Centre for Climate Change Economics and Policy. All potential errors are my own. Electronic supplementary material The online version of this article (https://doi.org/10.1007/s10640018-0230-3) contains supplementary material, which is available to authorized users. B Karlygash Kuralbayeva 1 Department of Geography and Environment, LSE, London, UK 123 K. Kuralbayeva JEL Classification H20 · H23 · H30 1 Introduction Environmental tax reform is one of the most effective tools that can be used in a fundamental transformation towards a green economy. When contemplating the introduction of environmental taxes, governments often consider whether such taxes, besides helping to achieve environmental goals, should also play a larger role in achieving other social and economic targets, such as reduction in unemployment rates. Previous studies, however, found that policies that reduce unemployment rates tend to be costly in terms of other policy objectives as they reduce private incomes, including those of people who are on state benefits.1 This makes it politically difficult to implement environmental policies. As a result, to make green tax reforms socially acceptable, economists have argued that complementary policies such as public spending cuts could be used to reduce the environmental tax burden on private sector income (see Koskela and Schob 1999; Bovenberg 1995). This paper evaluates the implications of this argument for unemployment and social welfare for the case of developing countries. The theoretical framework features an economy with three sectors: urban formal, urban informal, and rural agricultural. Following Pissarides (2000), search and matching frictions form the distinction between formal, or “regulated” jobs, and informal, or “unregulated” jobs. Workers in the informal sector search for jobs in the formal sector, and the unemployment rate is defined as the proportion of the labour force that is in informal-sector self-employment. The economy imports both energy and capital at given world prices to use as inputs in registered production activities. I consider three public spending policies: (1) as part of a revenue-neutral policy, (2) fixed, and (3) varying endogenously with GDP. As such, I study how various assumptions about public spending impact the effects of environmental policies on unemployment and social welfare. In this way, I am also able to compare the results with previous studies that have focused on revenue-neutral policies. Environmental policies considered in the paper are in the form of increases in energy tax rates. The model is calibrated to match some key aspects of labor markets in Mexico and is solved numerically. The three main findings of the paper are as follows. First, I find that the income of agricultural workers fall under all policy scenarios, even though they do not pay energy taxes. This is because the higher burden of taxation imposed on the unemployed prompts them to escape the brunt of taxation by searching for a job in the formal sector or by migrating into rural areas. This inflow of labor into the agricultural sector pushes wages down in that sector. This is the key difference to previous studies of the double dividend in the context of developed countries, as it shows the importance of modeling the Harris–Todaro effect (1970) when measuring the incidence of higher energy taxation on poverty within the context of developing countries. Second, I establish that relative to the scenario of revenue-neutral public policy, environmental tax policies with requirements on public spending, such as (2) and (3), are associated with a larger reduction in the unemployment rate and a lower reduction in after-tax private income. Intuitively, since labor taxes have a broad tax base, when public revenues are fixed there is less scope for the reduction of labor taxes under a revenue-neutral policy compared with when public spending is fixed or if the level of revenues can adjust endogenously. If 1 Bovenberg and van der Ploeg (1998a), Koskela and Schob (1999), Bovenberg (1995), Bovenberg and van der Ploeg (1998b). 123 Environmental Taxation, Employment and Public... it is also possible to reduce public spending, then the level of required public revenues can decline by more, which creates extra budgetary room for a further reduction in labor taxes, prompting an even larger increase in employment and a lower reduction in formal-sector after-tax income; in fact, the after-tax wage of formal workers increases in this case. Third, I evaluate the welfare implications of two environmental tax reforms under a taxation scheme that gives rise to a double dividend,2 and under the a (...truncated)