Optimal Tax Policy, Market Imperfections, and Environmental Externalities in a Dynamic Optimizing Macro Model

• Author: JHY‐YUAN SHIEH,JHY‐HWA CHEN,JUIN‐JEN CHANG,CHING‐CHONG LAI
• Published date: 01 August 2009
• DOI: http://doi.org/10.1111/j.1467-9779.2009.01423.x
• Date: 01 August 2009

OPTIMAL TAX POLICY,MARKET IMPERFECTIONS,

AND ENVIRONMENTAL EXTERNALITIES IN A DYNAMIC

OPTIMIZING MACRO MODEL

JUIN-JEN CHANG

Academia Sinica, Fu-Jen Catholic University,

National Central University

JHY-HWACHEN

Tamkang University

JHY-YUAN SHIEH

Soochow University

CHING-CHONG LAI

Academia Sinica, National Cheng Chi University,

Feng Chia University

Abstract

This paper develops a dynamic real business cycle model

that highlights pollution externalities (on welfare and pro-

duction) and market imperfections and uses it to determine

the socially optimal tax policy that encompasses labor in-

come, capital income, and emission taxes. We show that the

optimal tax on capital and labor income only addresses the

production inefficiency (and is time-invariant), while the tax

on the environmental externalities affects both the produc-

tion inefficiency and the environmental spillovers (and is

Juin-jen Chang, Institute of Economics, Academia Sinica, Nankang, Taipei 115, Tai-

wan (jjchang@econ.sinica.edu.tw). Jhy-hwa Chen, Department of Economics, Tamkang

University, Tamsui, Taipei Hsien 251, Taiwan (jhchen@mail.tku.edu.tw). Jhy-yuan Shieh,

Department of Economics Soochow University, 56, Kuei-Yang Street, Section 1, Taipei

(jyshieh@scu.edu.tw). Ching-chong Lai, Institute of Economics, Academia Sinica,

Nankang, Taipei 115, Taiwan (cclai@econ.sinica.edu.tw).

We are grateful to two anonymous referees who provided us with many insightful com-

ments and suggestions in relation to a previous version of this article. Wewould like to thank

Jang-Ting Guo for his helpful suggestions and discussions. Any errors or shortcomings are

our own responsibility, however. Financial support from the National Science Council is

also gratefully acknowledged.

Received November 27, 2006; Accepted March 23, 2009.

C

2009 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 11 (4), 2009, pp. 623–651.

623

624 Journal of Public Economic Theory

time-varying). More interestingly, the socially optimal emis-

sion tax will be characterized by a Keynesian-like stabilizer

that is designed to mitigate business cycle fluctuations, i.e.,

that will stimulate the economy with a lower emission tax dur-

ing recessions. In a positive analysis, we show that the benefi-

cial effects arising from pollution taxation will become larger

the greater is the degree of the firms’monopoly power. In

addition, a triple dividend in terms of improving environ-

mental quality and increasing employment and firms’profit

can be simultaneously realized if the environmental produc-

tion externality is more significant and if the elasticity of in-

tertemporal substitution in consumption is relatively small.

1. Introduction

The environmentis undoubtedly characterized by extensive externalities that

lie at the heart of environmental economics. These environmental externali-

ties may either be directly related to the damage to the household’s amenity

value (see, e.g., Huang and Cai 1994, Ligthart and van der Ploeg 1994, Michel

and Rotillon 1995), or indirectly related to the harm on the firms’factor pro-

ductivity (regarding the environmental production externality, one can refer

to Gradus and Smulders 1993, Bovenberg and Smulders 1995, Smulders and

Gradus 1996, Byrne 1997). In particular, empirical studies, such as Ballard

and Medema (1993) and Brendemoen and Vennemo (1994), point out that

environmental pollution lowers both the productivity of labor by harming

the public’s health and the productivity of physical capital by depreciating

the productive equipment. As a result, the economy-wide quality of the envi-

ronment can be thought of as a nonextractive productive service that affects

firms’production. In spite of these unfavorable externalities, most produc-

tion ultimately depends on the environment through the supply of inputs.

These environmental production externalities are more significant in devel-

oping countries than in developed countries, since environmental quality is

generally more related to rural economies or developing countries, where

production relies largely on natural resources (Rosendahl 1996, Bartolini

and Bonatti 2002).

On the other hand, intermediate goods markets (e.g., energy) are often

riddled with market imperfections because of the fact that a lack of prop-

erty rights may coexist with the presence of market power. Of importance,

as stressed by Fullerton and Metcalf (2002), the phenomenon of monopoly

power in polluting industries is more general. Using post-World War II data,

Hall (1986) reports mark-up ratios according to industry and finds that most

polluting industries included in this category exhibit substantial and high

market power.1Meanwhile, environmental concerns have also accelerated

1Of the seven industries included in this category that exhibit substantial market power,

four are significant polluting industries (chemicals, paper, motor vehicles, and primary