Many Western politicians have proposed increasing pollution taxes and cutting labour taxes in order to improve the environment, reduce unemployment and raise public spending. In Discussion Paper No. 869, Research Fellows Lans Bovenberg and Frederick van der Ploeg extend their previous work, which found that a shift towards greener preferences reduces employment when labour markets clear, to investigate the validity of such claims when a rigid, high consumer wage leads to involuntary unemployment. They examine optimal distortionary taxation, the marginal cost of public funds and the optimal level of public spending in the presence of wage rigidities and environmental externalities. Overall welfare is determined by the quality of the natural environment, public consumption and private consumption of commodities and leisure; measured private welfare is decomposed into income from profits and employment.

They first consider an economy in which pollution is an inevitable by-product of production. With no profit tax, increased concern for the environment raises public abatement, the labour tax and unemployment and reduces economic activity and private consumption. Total public spending rises, but public consumption rises only if the productivity of public abatement tapers off rapidly. With high taxation on profits, public consumption is likely to fall. They also consider a small open economy which imports natural resources from a competitive global market, while labour and another fixed factor are immobile. If there is substantial initial concern for the environment, the cost of additional public abatement now crowds out both private profits and public consumption. If there is initially little environmental concern, however, a shift towards greener preferences may yield a `triple dividend' of increased employment, reduced pollution and greater public consumption at the expense of profits if labour provides a better substitute for resources than the fixed factor. This result requires fixed factors to play a major role in production, however, which they are unlikely to do for open economies in the long run as economic integration proceeds.

Does a Tougher Environmental Policy Raise Unemployment? Optimal Taxation, Public Goods and Environmental Policy with Rationing of Labour Supply
A Lans Bovenberg and Frederick van der Ploeg

Discussion Paper No. 869, December 1993 (IM)