Taxation, Employment and the Environment - General Equilibrium Analysis with Unionised Labour Markets

We evaluate the effects of labour and environmental taxes in a general equilibrium model with unionised labour markets and involuntary unemployment. Environmental externality is related to the consumption of a polluting output. In particular, we examine whether a "double dividend" in terms of employment and the environment can be reaped with an environmentally motivated, revenue neutral tax reform. With unemployment benefits exempted from tax, we find that uncompensated increases in either labour income or environmental taxes lead to a lower equilibrium level of employment and polluting output. Numerical simulations with plausible parameter values show that employment will improve after the reform. The magnitude of the employment effect is considerable and depends positively on the share of polluting output in total consumption. However, due to the increased level of economic activity, environmental quality tends to deteriorate. This caveat can be avoided if tax cuts are targeted to the payroll tax in the non-polluting sector only. A prerequisite for the double dividend is that the elasticity of substitution between polluting and non-polluting consumption is large enough.