Optimal Environmental Tax Rate in an Open Economy with Labor Migration—An E-DSGE Model Approach

Abstract

Recent research has started to apply environmental dynamic stochastic general equilibrium (E-DSGE) models for climate policy analysis. However, all of the studies assume a closed economy setting, where there is no interaction of the economy with an outside economy; this paper fills the gap by constructing a two-city E-DSGE model that features labor migration. With the model, we solve for the optimal environmental tax rate determined by a Ramsey social planner, who maximizes household utility and takes into account the policy’s impact on labor migration. We find the following. (i) The optimal environmental tax rate should be more volatile and procyclical than the rates predicted in the aforementioned literature. (ii) In the closed economy setting, a higher environmental tax rate would always dampen production, while in our setting, it could stimulate output through deterring labor outflow and attracting labor inflow. (iii) We complement the existing literature by emphasizing that the optimal environmental tax rate in a city should respond not only to the shocks that occur internally, but also to those that occur in the opponent city. In particular, we find that it is optimal to reduce the environmental tax rate if a positive total factor productivity (TFP) shock occurs in the neighbor city.

Economic growth and environmental pollution in small-scale E-DSGE model. The case of Azerbaijan

“…Chan (2019) explores the optimal environmental tax rate in an open economy with labor migration. The author demonstrates that the optimal environmental tax rate volatility and procyclicality are underestimated in the previous literature because a higher environmental tax rate could stimulate output, deter labor outflow, and attract labor inflow [4]. Ramelli et al (2021) discovered that the unexpected success of the strike led to a decline in the stock prices of companies with high carbon intensity.…”

Green preferences

“…Although the analysis of the impact of supply shock on the environment is the main topic in the DSGE literature, some recent papers address this issue from another perspective, focusing on the economy's demand side. Chan (2019) explores the optimal environmental tax rate in an open economy with labor migration. His study is motivated by the idea that poor environmental quality could dissuade professional workers from immigrating to a city.…”

“…Starting from these contributions, we extend the investigation of the relationship between economic fluctuations and emissions in a framework that incorporates two kinds of goods and with a greater focus on pro-environmental consumption effects. More precisely, our model includes environmental awareness in household behavior as in Chan (2019) . However, we differ from this latter by not focusing on labor migration.…”

“…The experiment is similar toChan (2019). Notably, the author assumes that an increase in the emission stock affects labor disutility sensitivity; we apply the same methodology on consumption preferences.…”

Environmental Tax Reform and the “Double Dividend” Hypothesis in a Small Open Economy

“…Since then, this method has been widely adopted, and most studies support that the environmental tax usually benefits wealthy families and negates the double dividend of tax burden. Moreover, research on the double dividend of allocation usually shows that, whether in terms of horizontal income distribution or vertical welfare distribution, environmental taxes tend to be advantageous to the wealthier and aggravate income inequality [13]. In other words, there is no double dividend effect of distribution [14].…”