Elsevier Editorial System(tm) for Journal of Environmental Management
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Title: General Equilibrium Tax Incidence with Imperfect Factor Mobility
Article Type: Research Paper
Keywords: tax incidence; adjustment costs; environmental; general equilibrium
Corresponding Author: Mr. David Westfall Garrett, M.S.
Corresponding Author's Institution: Texas Legislative Budget Board
First Author: David Westfall Garrett, M.S.
Order of Authors: David Westfall Garrett, M.S.
Cover Letter
601B Carolyn Avenue
Austin, TX 78705
7038696951
west.garrett@gmail.com
June 2, 2007
Dr. A. Gill EditorinChief, Journal of Environmental Management 1620 Acton Street Berkeley, CA 94702
Dear Dr. Gill:
Enclosed in this mailing is my manuscript, “General Equilibrium Tax Incidence with Imperfect Factor Mobility.”
The best way to reach me is through my email address or my cell phone, listed above. You can also find more information about me and my research via my website:
http://www.westgarrett.com. Thank you for your time and consideration.
Sincerely,
West Garrett
Manuscript
General Equilibrium Tax Incidence with Imperfect Factor Mobility
David Westfall Garrett 601B Carolyn Avenue Austin, TX 78705
703.869.6951 (cell)
Legislative Budget Board 512.463.7701 (work)
512.475.2902 (fax)
west.garrett@gmail.com
http://www.westgarrett.com
June 2, 2007
2
Abstract
This paper examines the effect of adjustment costs on environmental tax incidence, using
a general equilibrium model with two factors of production: a nonpolluting resource, either labor
or capital, and pollution. This model shows that introducing capital adjustment costs changes
both the price of the dirty good and the rental rate of capital relative to a model that assumes
perfect capital mobility (the standard assumption in prior work). Labor adjustment costs lead to
a drop in labor supply and pollution but do not affect output prices or the wage. In general, the
tax incidence is greater in these imperfect factor mobility models.
3
Power plants emitting sulfur dioxide, explosives blasting mountaintops to extract coal,
and farm runoff carrying pesticides into lakes and rivers are all examples of pollution. To
mitigate the negative effects of this externality, governments often try to correct the market
failure by implementing an environmental tax. Consumers, firms, and workers may share some
of the burden of this tax. These economic agents face burdens in the form of changes in rates of
return, prices, and quantities. A general equilibrium model can capture this incidence using an
analytical framework with closedform solutions; also, this type of model can provide policy
makers with a clearer picture of who shares the burden of an environmental tax.
Previous literature provides models of environmental tax incidence in a general
equilibrium framework. Many of these models, including Fullerton and Heutel (2005), assume
that inputs are perfectly mobile across sectors. These results may differ if the models do not
assume that inputs, such as capital and labor, are perfectly mobile, because adjustment costs
likely entail a larger burden for firms, workers, and owners of production inputs.
The purpose of this paper is to incorporate costs of capital adjustment to a firm, or costs
of labor adjustment to a worker, into the framework of Fullerton and Heutel (2005), which
examines environmental taxes in a general equilibrium model. By entering adjustment costs into
this model, this paper explores the distributional burden of a small additional environmental tax
on pollution. The paper examines two possible cases: first, a capital adjustment cost for the firm;
and second, a labor adjustment cost for the worker. These adjustment costs are quite different.
The former detracts from output in a manner similar to Goulder and Summers (1989), and the
latter detracts from the total resource constraint. Using these two extensions of the Fullerton and
Heutel (2005) model and implementing different functional forms for the adjustment costs, this
paper reexamines general equilibrium tax incidence.
4
Some examples lead one to think that factors of production are not perfectly mobile
across sectors. First and foremost, firms are likely to alter the amount of their capital stock and
thus pay a cost of adjustment. In the case when firms lay off workers, those workers may also
suffer a cost of adjustment (Jacobson, LaLonde, and Sullivan 1993). Specifically, a tax on
pollution from coal mining may induce coalproducing firms to invest in equipment that extracts
coal in a cleaner manner. Similarly, if the firm has to lay off some of its workers, the workers
may need training for a new job, and/or to move to a new place, so this change would also entail
a considerable cost. As a result, costs of adjustment in an environmental general equilibrium
model can provide a new perspective on the burdens of tax changes.
The contributions of this work are to relax the prominent assumption in many economic
models, including Fullerton and Heutel (2005), of perfect factor mobility, by incorporating costs
of adjustment into a general equilibrium model on environmental taxation. This paper uses a
clean good and a dirty good, like Fullerton and Heutel; but this paper uses only one input to the
clean good, and two inputs (pollution and either capital or labor) to the dirty good. The reason
for this simplification is that this paper focuses on the issue of adjustment costs, and an extension
of this paper could entail the generality of a threefactor model with adjustment costs. When
capital is the clean input, this paper subtracts capital adjustment costs from the firm’s production
function, in a manner similar to that of Goulder and Summers (1989). Next, this paper changes
the primary input from capital to labor, and adds labor adjustment costs for the worker, taking
into account the need to reflect some inherent differences between these two cases.
The results of this paper find that incorporating labor adjustment costs for workers into
the basic model leads to a drop in the labor supply in both sectors, and in pollution, than the
results of Fullerton and Heutel (2005). Since prices do not change relative to the Fullerton
5
Heutel result, and the change in the labor supply in both sectors is less, workers are worse off in
the economy with adjustment costs. Nonetheless, including capital adjustment costs for firms
into the basic model does not necessarily lead to the same result. In this model, the price of the
dirty good and the rental rate of capital change relative to the FullertonHeutel result, and the
change in capital in one sector is positive, while the change in the other sector is negative,
relative to the basic model. Clearly, this paper finds that the solutions to a general equilibrium
model with imperfect factor mobility depend on the nature of the adjustment costs. As this paper
also shows, the solutions also depend on the structure of the adjustment costs.
The first section of this paper presents the basic general equilibrium model with a tax on
pollution. Section II incorporates capital adjustment costs to the firm into the model to illustrate
how the distributional burden of the tax changes. Next, Section III replaces the capital input with
the labor input, and adds labor adjustment costs to the workers into the model. Then Section IV
compares the results of the two cases and examines how the nature of adjustment costs affects
the distributional burden of an environmental tax. Finally, the paper concludes and considers
future research in this field.
I. BASIC MODEL WITH TWO FACTORS OF PRODUCTION
This basic model uses features similar to the models of Harberger (1962) and Fullerton
and Heutel (2005). Like Fullerton and Heutel (2005) (hereafter referred to as FH), this model
solves for all changes in prices and quantities due to an exogenous increase in the pollution tax.
Since this model does not attempt to examine the elasticities between different inputs into
production, it is less general than FH because this model only offers one clean input into
production. The reason for this change is the goal of this model is merely to examine a general
equilibrium model with an exogenous increase in the tax on pollution. The models in Sections II
6
and III of this paper have more generality than FH since they account for adjustment costs. The
constant returns to scale production functions in this basic model are the following:
X = R
X
Y
=
Y (R , Z)
Y
where X is the clean good, Y is the dirty good, and R
X and R
Y are clean inputs into production,
or “resource” inputs representing either labor or capital. The resource constraint is the
following:
R
X
+
R
Y
=
R
[1.1]
where R is the fixed total amount of resources in the economy. Totally differentiating this
constraint yields:
ˆ
R λ
X
RX
+
ˆ
R λ
Y
RY
= 0
[1.2]
ˆ
where a hat denotes a proportional change ( R
X
≡
dR
X
/ R
X
), and
λ
ij
denotes sector j ’s share of
factor i (e.g. λ
RX
≡
R
X
/
R
). Since Z does not have a resource constraint, then imposing a pre
existing positive tax on pollution ensures that the use of pollution is finite in the initial
equilibrium (FH).
In this model, the only tax is the one on pollution. Producers of sector Y can substitute
between R
Y
and Z depending on their respective factor prices,
p
R
and p , and according to the
Z
elasticity of substitution in production,
yields
ˆ
R
Y
− Z ˆ = σ
Y
( p ˆ
Z
− p ˆ
R
)
σ
Y
(FH). The differentiation of σ
Y
using its definition
[1.3]
7
where σ
Y
is positive by definition. The firm’s resource cost is p
_{R} =
r
, where r is the net return
to investors on the resource input. Also, the price of pollution is equal to its tax, so that p
Differentiating these equations and defining τˆ
Z
ˆ
p
pˆ
R
Z
= r ˆ
= τˆ
Z
≡ dτ
Z
/τ
Z
yields
Z
= τ
Z
[1.4]
[1.5]
.
Then substituting [1.5] and [1.4] into [1.3] yields the following equation:
ˆ
R
Y
−
Z ˆ
= σ
Y
( ˆ
τ
Z
−
r ˆ)
[1.6]
As shown in an Appendix (available from the author upon request), this model uses the
assumptions of perfect competition and constant returns to scale to derive the following two
equations for the zero profits condition:
ˆ
p
ˆ
p
X
Y
ˆ 
ˆ 

X 
ˆ 
R 

+ 
= 
r 
+ 

ˆ 
+ Y = θ
YR
X
(ˆ
ˆ
r + R
Y
)
+θ
YZ
z +τ ˆ
(ˆ
Z
[1.7] 

) 
[1.8] 
where
θ
YR
≡
r
⋅
R
Y
/
p
Y
⋅
Y
is the share of sales revenue of sector Y paid to resources, and p
X
p
Y
are output prices. Also,
θ
YZ
≡ τ
Z
⋅
Z
/
p
Y
⋅
Y
is the share of revenue of sector Y paid for
pollution, in the form of taxes. Since these ratios are shares, then
θ
YR
+
θ
YZ
= 1
.
and
Totally differentiating each sector’s production functions, and substituting in the
conditions for perfect competition, yields the following equations:
ˆ
X
Y ˆ
=
R ˆ
X
= θ
YR
R ˆ
Y
+ θ
YZ
Z ˆ
[1.9]
[1.10]
8
The last step is to formulate the definition of the elasticity of substitution between goods X and
Y
in utility,
σ
U
. Differentiating this definition yields the equation for the consumer demand
response to a change in prices (FH):
X − Y ˆ = σ
ˆ
U
( p ˆ
Y
− p ˆ
X
)
[1.11]
ˆ
Equations [1.2], [1.6][1.11] are seven equations in eight unknowns ( R
X
ˆ
, R
Y
,
ˆ
Z
, r ˆ, p ˆ
X
In order to eliminate one equation, good X becomes the numeraire good, so that
p
X
, p ˆ
Y
= 1
and p ˆ
X
= 0
. Therefore, this system of seven equations provides the general equilibrium
,
ˆ
ˆ
X Y ).
,
solutions to all seven unknowns as functions of the parameters and the exogenous increase in the
pollution tax (
τˆ
Z
>0) in a similar manner to that of FH.
The goal of this paper is to solve for the incidence results, the effects on output and factor
prices. In addition to the work of FH, this paper explicitly solves for the quantities R
X
ˆ ˆ
and R
Y
,
since this paper also examines how the pollution tax affects labor supply (i.e. when R is labor),
ˆ ˆ
when workers face adjustment costs. Finally, this paper omits the explicit solutions for X and Y .
This paper derives the following solutions to the general model:
pˆ
Y
= θ
YZ
τˆ
Z
rˆ = 0
ˆ
Z
ˆ
R
ˆ
R
( σ Y (1 + θ 
YR 
γ R 
) + σ θ U 
YZ 
γ R 
) 

θ YZ ( σ U − 
1 + σ Y ) 
γ R ˆ 

= − = = X 1 + γ R ( σ Y γ θ R YZ 
− 
τ Z σ U ) 

Y 
1 + γ 
R 
ˆ τ Z 
ˆ
τ
Z
[1.12a]
[1.12b]
[1.12c]
[1.12d]
[1.12e]
9
where
γ
R
≡ λ
RX
/ λ
RY
. The net return to investors on the resource input does not change because
the clean good X uses a oneforone production function with R
X as the only input. Since this
paper chooses p
X
as the numeraire, then pˆ
X
= pˆ
R
= rˆ = 0 . The simple production function for
good X also affects equation [1.12a], since the effect on p
Y only comes from the dirty input and
not from the clean input. Since the change in the pollution tax is positive, then the change on the
output price of good Y , pˆ , is also positive and depends on the share of pollution in the dirty
Y
ˆ
sector. On the contrary, Z is negative since this paper defines all the parameters and elasticities
in the brackets as positive, and the change in the pollution tax is positive. The magnitude of
ˆ
Z depends in part on both the elasticity of substitution of inputs into the dirty good,
σ
Y
, and the
elasticity of substitution of the output goods,
σ
U
. Therefore, in this basic model, the increase in
the pollution tax leads to an improvement in environmental quality.
ˆ
For both R
X
ˆ
and R
Y , the sign and the magnitude of each quantity change depend on the
two elasticities of substitution. In the CobbDouglas case, when σ
Y
= σ
U
, the increase in the
pollution tax has no effect on the supply of the resource input in each sector. In the more general
case, when σ
Y
≠ σ
U
, and when
σ
U
is greater, the resource input in sector X increases, but the
resource input in sector Y decreases. Thus, when the output elasticity of substitution is
relatively high for consumers, consumers substitute away from buying the dirty good and instead
buy the clean good, leading to an increase in the resource used in the clean sector. Yet, when the
factor elasticity of substitution is relatively high for firms, dirty firms use relatively more of the
resource, so
ˆ
R
X
ˆ
is negative, and R
Y
is positive.
II. MODEL WITH CAPITAL ADJUSTMENT COSTS FOR THE FIRM
A. General Model with NonLinear Adjustment Costs
10
This section uses capital as the “resource” input into production and incorporates
adjustment costs for firms into the model. Equations [1.1][1.8] and [1.11] remain the same as
when adjustment costs do not appear in the model, except that the “R” becomes a “K.” Using
aspects of Goulder and Summers (1989), this paper assumes that output is separable between
inputs and adjustment costs and incorporates adjustment costs for firms into the production
function, Equations [1.9] and [1.10]. This formulation demonstrates that when a firm adjusts its
capital stock, this change results in a net loss of output.
The adjustment costs in this paper abide by certain conditions. First, similar to the
adjustment cost function ϕ( I / K ) of Goulder and Summers (1989), the adjustment comes in a
relative form; the function is
ˆ
(
ϕ K
X
),
not
ϕ dK
(
X
)
. However, while Goulder and Summers
(1989) consider gross investment, this paper examines the following case: firms only face
adjustment costs when they alter net investment. In order to make this change from some
previous literature, this paper assumes that replacement investment incurs no adjustment cost,
ˆ
and that the depreciation rate is sufficiently large to allow for no costs of adjustment when K
X
ˆ
or K
Y is negative. Thus, parts of the Goulder and Summers (1989) model change by assuming
that firms only incur adjustment costs when the change in the capital stock is positive (i.e.
ˆ
K
X
,
ˆ
K
Y
>0). Finally, the adjustment cost function is the same in both sectors.
Using these features, after total differentiation, the production function equations become
the following:
ˆ
X
ˆ
Y
= K ˆ
X
ˆ
(
− ϕ K
X
)
= θ
YK
K ˆ
Y
+θ
YZ
Z ˆ − ϕ K
(
ˆ
Y
[2.9] 

) 
[2.10] 
11
where the adjustment cost ϕ is a nonlinear function of the change in the capital stock. The key
is the adjustment cost ϕ represents an additional burden in each sector.
Equations [1.2], [1.6], [1.7], [1.8], [2.9], [2.10], and [1.11] are seven equations with the
same eight unknowns as before. Again, good X is the numeraire, so the model becomes a
system of seven equations and seven unknowns. As shown in an Appendix, the general solutions
are the following:
ˆ
p
Y
ˆ
= θ
τ
YZ
Z
ˆ
r ˆ = −ϕ K
(
X
ˆ
(
+ ϕ K
Y
)
)
ˆ
−θ
ϕ K
YK
(
X
) 
[2.12a] 
[2.12b] 
ˆ
Z
= −
(
ϕ
ˆ
K
X )
ˆ ˆ
K
X
=
( K
ϕ
X
)
( 
θ YK 
γ K 
( σ 
Y 
− 
σ U ) 
+ 
σ 
Y + γ K ) 

θ 
1 + γ K σ θ 

(1 − 
σ 
U 
YK 
− 
Y YZ 
) 
− ( ϕ ˆ K Y ) 

1 +
γ
K
+
ϕ (
ˆ
K
Y ) (
γ
K
(1
1 +
− σ
U
γ
K
))
(1
−
1 +
σ
U
γ
K
)
+
(
θ
YZ
(
σ
U
−
1 +
γ
K
( σ
U
θ
YZ
γ
K
+
(1
+
θ
YK
γ
K
)
σ
Y
)
−
σ
Y
))
ˆ
τ
Z
1 +
γ
K
ˆ
τ
Z
ˆ
K
ˆ
(
Y K
=
ϕ
X )
(
γ
K
(
σ
U
θ
YK
+
σ θ
Y
YZ
−
1))
1 +
γ
K
+
ϕ (
ˆ
K
Y ) γ
K
(1
1 +
− σ
U
γ
K
)
+
(
γ θ
K
YZ
(
σ
Y
− σ
U
))
1 +
γ
K
ˆ
τ
Z
with the last three equations as [2.12c, d, e].
In this general model, this paper has not yet specified the form of the adjustment cost, _{ϕ} .
As a result, the solutions to this general equilibrium model are not closedform solutions.
Nonetheless, one can still interpret these solutions to the general nonlinear adjustment costs
case. In Equation [2.12b], the change in the rate of return to capital owners is no longer always
zero. Since
ˆ
(
ϕ K
X
)
is positive when
ˆ
K
X is positive, the change in the rate of return is potentially
ˆ ˆ
negative. From Section I, when K
X
is positive,
K
Y
is negative. For this particular case,
ˆ
(
ϕ K
Y
)
is zero since firms do not incur adjustment costs when the change in the capital stock is negative.
ˆ
When K
X is positive, the change in the price of the dirty sector falls, but not by as much as the
12
change in the rate of return falls, since θ
YK
<1. Therefore, compared to the FH model in Section
I, this economy experiences a net loss. Consumers gain by
owners lose.
p
Y falling, but firms and capital
Like the price and rate of return changes, the three quantity changes [2.12c, d, e] nest
solutions to the basic model of Equations [1.12c, d, e] whenever ϕ is zero. An Appendix shows
ˆ
that because all three terms on the righthand side for K
ˆ
X and K
ˆ
Y are opposite in sign, then K
ˆ
and K
Y must have opposite signs, meaning that firms in one sector incur adjustment costs of
X
increasing the capital stock. This result is consistent with Section I. Furthermore, one finds that
if
σ
Y
>
σ
U
> 1
, then the change in pollution in this equilibrium is unambiguously more negative
than that in Section I, indicating that the environmental quality improves. However, this case
may be the only one in which that result holds. Since this system of equations is simultaneous,
this paper considers special cases and examines specific functional forms for the adjustment
costs.
One special case occurs when both the utility function and the production function in the
dirty sector are CobbDouglas. By examining the further special case when both of these
elasticities are unity, one finds that no capital moves across sectors (i.e.
ˆ
K
X
ˆ
and K
Y
are zero).
By assumption, the adjustment costs are also zero, and the equilibrium remains the same as with
perfect factor mobility.
B. A Special Case:
ˆ
(
ϕ K
X
),
ˆ
(
ϕ K
Y
)
are Linear
13
The paper now considers the case when the adjustment costs are linear ^{1} . Thus, the
adjustment costs follow the functional form that ϕ(
ˆ
K
X
) = ϕ ⋅
ˆ
K
X
ˆ
, and ϕ >0 when K
X is positive,
and ϕ =0 otherwise. As shown in an Appendix, with linear adjustment costs, the results are as
follows: ˆ = 
[( ϕ σ Y 
− σ U )( θ YZ 
( γ K 
+ 
))] σ ϕ Y 
ˆ 

r ˆ 
( γ K + σ ϕ Y ){1 + θ YK = θ YZ ( γ K + σ ϕ Y ){1 
γ K + [ ϕ σ U ( θ YK + θ γ YK K − (1 ϕ + 
+ γ K γ K ) 
) + 
− (1 θ YZ + γ ( γ K 
K )] + θ YZ + )} σ ϕ Y 
( γ K + )} σ ϕ Y τ + ϕ σ θ [ Y YZ ( γ K 
p
Y
(
γ
K
+
σ ϕ
Y
){1
+
θ
γ
YK
K
+
[
ϕ σ
U
(
θ
YK
+
γ
K
)
−
(1
+
γ
K
)]
+
θ
YZ
Z
(
γ
K
+
ˆ
Z =
ˆ
K X
ˆ
K
Y
− 
{ σ θ U 
YZ ( γ K + 
) σ ϕ Y + 
σ Y (1 + 
θ γ YK K + [ ϕ σ 
U 
( θ YK + γ K ) − (1 + 
γ 
K )])} 
ˆ 

= 
1 
+ θ γ YK K 
+ 
[ ϕ σ U − 
( θ YK [( σ Y + − 
γ K ) − (1 + γ K σ U )( θ YZ ( γ K 
)] + 
+ θ YZ ( γ K ))] σ ϕ Y + σ ϕ Y 
) 
τ Z 

= 
( γ K 
+ 
σ ϕ Y ){1 
+ 
θ γ YK K γ K 
+ [ ϕ σ [( σ Y − 
U ( θ YK + γ K ) σ U )( θ YZ ( γ K 
− + 
(1 + γ K )] σ ϕ Y ))] + θ YZ ( γ 
K 
+ )} σ ϕ Y 

( γ K 
+ 
σ ϕ Y ){1 
+ 
θ γ YK K 
+ [ ϕ σ 
U ( θ YK + γ K ) 
− 
(1 + γ K )] + θ YZ ( γ 
K 
+ )} σ ϕ Y 
τ
Z
)(
σ ϕ
Y
θ
YK
+
γ
K
)]
+
ˆ
τ Z
ˆ
)}
σ ϕ
Y
ˆ
τ
Z
with these five equations as [2.13a, b, c, d, e]. This special case of linear adjustment costs leads
to a system of closed form solutions to the general equilibrium.
These solutions show that the sign of the change in the rate of return on capital depends
on whether σ
U
or
σ
Y is greater. When the elasticity of substitution of inputs within the dirty
ˆ
sector is greater, then K
X
is negative, and
ˆ
(
ϕ K
X
)
is zero by assumption, so as a result, rˆ equals
zero as in Section I. In this example, capital owners do not lose relative to the equilibrium in
Section I. In the case when σ
U is greater, then the change in the rate of return on capital is most
likely negative. Consumers buy more of the clean good, firms increase capital in the clean
^{1} This paper also attempts to solve analytically the interesting case of quadratic adjustment costs. However, the only way one can solve this case is to do so computationally because this case is not analytically tractable.
14
sector, and capital owners receive a lower rate of return than prior to the increase in the tax.
While the linear adjustment cost case provides closedform solutions to the equilibrium, the signs
of the change in the price in the dirty sector and the change in pollution are ambiguous.
III. MODEL WITH LABOR ADJUSTMENT COSTS FOR WORKERS
A. General Model with NonLinear Adjustment Costs
Using labor as the “resource” input in this section so that the “R” in Section I becomes an
“L,” the goal is to examine the changes in labor supply, prices, and pollution when the model
incorporates both an increase in the pollution tax and adjustment costs for workers. This paper
ˆ
assumes that workers only experience adjustment costs when firms lay them off (i.e., when L
ˆ
and L
Y are negative). The worker adjustment costs may include the following possibilities:
X
moving to a new place, receiving new job training or pursuing further education, searching for
new jobs, and dealing with the psychological issue of losing one’s job (Koeppel 1993). The
Washington Post studies the last concern by reporting the following:
…Pan Am, the onetime aviation giant, went under. When its remaining 12,000 employees arrived at work on Dec. 4, 1991, security staff gave them one hour to clear out. A year and a half later, suicide among these laidoff workers has reached epidemic proportions. Since Pan Am’s demise, eight former employees have killed themselves—double the normal rate for men in their forties and fifties.
In modeling this general occurrence of labor adjustment costs, Equations [1.1] and [1.3]
[1.11] remain the same as Section I when the workers do not experience adjustment costs. The
adjustment costs appear in the differentiated resource constraint, Equation [2], so that leaving
one sector causes workers to lose labor time:
ˆ
L λ
X
LX
where
+
ˆ
L λ
Y
LY
ˆ
Ψ L
(
X
),
+ Ψ
ˆ
Ψ L
(
(
ˆ
L
Y
)
X
)
+ Ψ
(
ˆ
L
Y
)
=
0
[3.2]
are nonlinear adjustment costs as a function of the change in the labor
supply in each sector. Again, this paper assumes that the adjustment cost function is the same in
15
both sectors. The reason the adjustment costs appear in this equation is that with a fixed labor
supply, workers can no longer move in a costless manner from one sector to another. In effect,
they lose some resources when firms dismiss them.
Equations [3.2] and [1.6][1.11] are seven equations with eight unknowns and good X as
the numeraire. The equilibrium results are the following:
pˆ
Y
= θ
YZ
τˆ
Z
wˆ = 0
ˆ
Ψ
ˆ
( L
)
+ Ψ
(
ˆ
L
)
[
σ
(1
+
θ
+
σ θ
X 
Y 
Y YL L 
U 

λ LY 
(1 
+ γ L ) 
− 
1 + 
γ L 

ˆ 
ˆ 

Ψ ( L 
X 
) 
+ Ψ ( 
L Y 
) 
θ [ YZ ( σ U − σ 
Y )] 
ˆ 

λ LY 
(1 + γ L 
) 
+ 
1 + γ L 
τ 
Z 

Ψ ( ˆ L 
X 
) 
+ Ψ ( 
ˆ L 
Y 
) 
− 
γ θ [ L YZ ( σ U − 
σ 
Y 
)] 
ˆ τ 
λ LY 
(1 + γ L 
) 
1 + γ L 
Z = −
ˆ
L
ˆ
L
X
Y
= −
=
−
YZ
Z
γ
)
γ
L
]
ˆ
τ
Z
[3.12a]
[3.12b]
[3.12c]
where wˆ is the net wage, and the last two equations are [3.12d, e]. The first thing to note is that
the adjustment costs have the same negative effect on all three quantity inputs. If
ˆ
Ψ L
(
ˆ
Ψ L
(
Y
) are both equal to zero, then the equilibrium reduces to the FH result. Since the
X
)
and
adjustment cost terms are positive, each of the changes in the three inputs is more negative than
in Section I. Consequently, the change in pollution is strictly more negative when workers face
adjustment costs; this result indicates that everyone enjoys the change toward a more ambient
environment more than they do in the FH result. Nonetheless, since the change in labor supply
in both sectors is more negative than in Section I, and since wˆ and pˆ
Y remain the same, workers
in both sectors are worse off in this economy. The rationale behind this result is that adjustment
costs do not affect consumers and firms directly. The model shows that the pollution tax
16
increase and the labor adjustment costs lead to a reduction in labor supply in both sectors, and
this friction in the labor market causes the change in the environmental quality to be cleaner than
in the FH model.
Since equations [3.12c, d, e] are not explicit functions of the parameters and
τˆ
Z
, then this
paper considers two special cases of adjustment costs: a linear case and a quadratic one.
Modeling these two special cases is interesting because linear adjustment costs may apply more
readily for workers in urban areas, whereas quadratic adjustment costs may be more appropriate
for modeling the situation of workers in rural areas. In an urban area, workers are more likely to
enjoy easy access to retraining, new education, and other job possibilities. Also, dismissed
workers in cities likely may not have to move to find new work. Conversely, in a sparsely
populated area, as the number of unemployed workers increases due to a tax, the adjustment
costs of finding a new job increase exponentially, and consequently, so does the tax burden on
the workers. In this type of area, the dirty sector may comprise almost all of the jobs, meaning
that a massive layoff may affect almost everyone in a small area. This situation implies that
many of these rural workers would likely have to move to a new and unfamiliar area.
B. Special Cases
form is
Case 1:
Ψ(
ˆ
L
X
)
ˆ
Ψ L
(
X
= Ψ
LX
),
ˆ
Ψ ( L
Y
)
are linear. When the adjustment costs are linear, the functional
⋅
ˆ
L
X
ˆ
when L
X
is negative, and
Ψ
LX
=0 otherwise. The only equations that
change from the general model in this section are the three quantity inputs, Equations [3.12c, d,
e]. The resulting equations for the linear case, Equations [3.13c, d, e], are as follows:
17
ˆ Z = − 
[ σ Y ( λ LY + Ψ LY + θ 
YL 
( λ LX 
+ Ψ LX )) 
+ σ U θ 
YZ ( λ 
LX 
+ Ψ LX 
)] 
ˆ 

ˆ θ [ = YZ ( σ U − σ 
Y )( λ LY + Ψ LY λ LY + Ψ LY )] 
λ LX + Ψ LX 
τ Z 

L X ˆ L 
= 
λ LY + θ [ YZ ( σ Y Ψ LY − σ 
+ λ LX U )( λ LX 
+ Ψ LX + Ψ LX 
)] 
+ ˆ τ Z ˆ 

Y where 
λ LY Ψ LX + Ψ LY + λ LX + Ψ LX τ Z and Ψ LY ˆ are the linear adjustment costs in the clean and dirty sectors, respectively. ˆ ˆ 

Again, the result is Z <0, and the sign of L X 
, L Y 
strictly depends on which elasticity of 
substitution is greater. In the CobbDouglas case of σ
U
= σ
Y
, then labor supply does not change
in either sector, and consequently, workers do not face adjustment costs.
In the general example, one sector’s labor supply change is positive, and the workers in
this sector do not incur an adjustment cost. Consider the following example:
σ
U
> σ
Y
, so that
the change in the clean sector is positive, and therefore, Ψ
LX
= 0 . From these closedform
solutions for the linear case, as I demonstrate in a proof at the end of the paper, the change in the
labor supply in the dirty sector in Equation [3.13.e] is more negative than from the FH model.
Also, the change in the labor supply in the clean sector in Equation [3.13.d] is more positive than
from Section I. This second result likely only holds due to the assumption that Ψ
LX
= 0 .
The
ˆ
key finding from this example is that the negative double difference change in L
Y is larger in
absolute value than the positive double difference change in
ˆ
L
X , indicating that the model with
adjustment costs experiences a larger net loss in the change in labor supply than the FH model
(see proof). Again, since the net wage and output prices do not change from the Section I model,
then workers clearly lose more in the economy with imperfect factor mobility.
18
Case 2:
ˆ
Ψ L
(
X
),
ˆ
Ψ L
(
Y
)
are quadratic. The functional form of the quadratic adjustment
costs follows that of Cahuc and Zylberberg (2004):
Ψ
(
ˆ
L
X
)
= Ψ
LX
ˆ
⋅ L
2
X
ˆ
when L
X is negative, and
zero otherwise. This paper achieves a numerical result by choosing parameter values very
similar to those in FH (see Table 1). Also, this paper allows for three possible values of
σ ,
Y
since stylized facts do not provide as much information about this parameter.
In Figures 13, this paper plots the three quantity changes as the dependent variable and
the exogenous increase in the environmental tax as the independent variable. Figure 1
demonstrates that the change in pollution is a linear and decreasing function of the change in the
tax rate. When σ
Y is higher, so that substitution in production of good Y is more elastic, the
increase in the price of pollution causes firms to substitute more toward the labor input, and the
reduction in the change in pollution is greater. Note that if σ
Y is large, then firms reduce labor
supply in the clean sector (see Figure 2). As firms lay off these workers, adjustment costs take
effect; then the reduction in the labor supply in the clean sector escalates in an exponential
manner. Finally, in looking at the change in the labor supply in the dirty sector, one finds that
this supply also decreases as the tax rate increases. The key policy result shown from these
illustrations is when σ
Y and the tax rate increase are both fairly large, workers in both sectors
undergo a large reduction in labor time, and therefore bear a significant share of the tax burden.
Nonetheless, the change in pollution is noticeably lower, indicating the tradeoffs in the economy.
IV. COMPARING THE RESULTS
One way to examine the two types of adjustment costs would be to consider labor as the
only clean input into production. Then in Section II, the adjustment costs would be labor
adjustment costs for a firm when it hires or fires workers. This paper chooses to model capital
instead of labor, simply because many macroeconomic models consider capital adjustment costs
19
(Summers 1981; Adda and Cooper 2003). Nonetheless, evidence shows that labor adjustment
costs for a firm clearly exist (Hamermesh 1989; Hamermesh and Pfann 1996). Therefore, the
primary difference between Section II and Section III of this paper is not whether capital or labor
is the clean input in production; the main difference is whether firms or workers face adjustment
costs.
Section II finds that adjustment costs for firms do not have a distinctly negative effect on
the use of all three quantities inputs, as they do for workers. Another distinction between
adjustment costs for workers and firms is that in Section II, the prices and rates of return change
relative to the Section I result. In Section III, prices are the same as the FH result, so to find the
tax burden on workers, this paper focuses on the quantity changes of the labor supply.
V. CONCLUSION
The goal of this paper is to examine tax incidence in a general equilibrium model with an
exogenous increase in an environmental tax on pollution. This increase in the tax may reduce
pollution and improve environmental quality, but this environmental protection entails costs for
some economic agents. In providing a model with imperfect factor mobility, this paper shows
that these costs become even greater for some individuals when a government imposes an
environmental tax.
This paper relaxes the assumption of perfect factor mobility inherent in many general
equilibrium models by adding two types of adjustment costs. This paper models the firm
adjustment costs into the production function and the worker adjustment costs into the resource
constraint. The labor adjustment cost model reveals a somewhat surprising result: the
environmental quality improves more than in the case without adjustment costs. This finding
illustrates that while the tax accomplishes its initial goal, the tradeoff is that firms initially cannot
20
reemploy their workers. As a result, the tax burden for workers is greater in this economy than
one with perfect factor mobility. Likewise, when firms face adjustment costs, investors receive
lower rates of return, and firms suffer from lower prices than when they can easily adjust their
capital stock. Therefore, one public policy implication is that although environmental quality
may improve when the government imposes a tax, some economic agents suffer. This suffering
is greater when factors of production are not perfectly mobile.
The primary limitation of this paper is not deriving the solutions to the whole transition
path of the general equilibrium model using dynamic programming. Instead, this paper finds
results for the equilibrium in the period after the change in the environmental tax. Consequently,
these results are not consistent with a longrun equilibrium, as they are in previous papers with
adjustment costs, such as Goulder and Summers (1989). The most constructive way to extend
this paper would be to incorporate dynamics into the framework of the model.
21
Proof of Section III. B. Case 1 Result
This proof uses the notational definitions that
λ
LX
γ
L
=
λ
LX
+
λ
LY
1 +
γ
L
and
λ 
LY 
= 
^{1} 

λ LX ˆ L AC 
+ = 
λ LY [ θ YZ ( 1 + γ L σ U − σ 
and begins with the following results: Y )( λ LY + Ψ LY )] ˆ 

X 
τ Z 

λ LY θ + Ψ LY 
+ λ LX λ 
+ Ψ LX + Ψ 
where the AC stands for the adjustment costs result. 

ˆ L AC 
= 
[ YZ ( σ Y − σ 
U )( LX LX )] 
ˆ 

Y ˆ FH L 
= 
λ LY θ YZ ( σ 
+ U Ψ LY + λ LX − ) σ Y λ LY 
+ Ψ LX ˆ 
τ Z 

X ˆ FH L 
= 
θ YZ λ LX ( σ Y + λ LY − ) σ U λ LX 
τ Z ˆ 

Y 
τ Z 

λ LX + λ LY 
ˆ 

In the case when σ U > σ 
Y , the result is L X > 0 , and then by assumption Ψ LX 
= 0 . 

ˆ FH L 
− L ˆ AC X = 
λ LY 
− 
λ LY + Ψ LY − λ = LX Ψ LY 

X 
λ LY 
λ LX + λ LY 
+ Ψ LY 
( 
λ LX + λ LY )( λ LX + λ LY + Ψ LY 
) 

ˆ 
λ LX + 

⇒ L 
FH < X L ˆ AC X 

In addition, ˆ FH L − L ˆ AC 
1 
− 
1 
Ψ = LY 

Y 
Y 
( 
λ LX + λ LY )( 
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