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Article Excerpt
A number of recent studies on taxation in the presence of externalities in a second-best framework consider the implications of taking into account the feedback effects of environmental quality. This paper explores by means of GEM-E3, a computable general equilibrium model for the EU countries, the importance of the feedback effects of the health related benefits from an environmental policy. The modelling framework implemented in GEM-E3 allows for three channels through which the feedback can occur: a decrease in medical expenditure, an increase in the consumers' available time and an increase of labour productivity in the production sectors. The results show that the explicit modelling of the health related effect of air pollution on consumers and producers allows for a more precise evaluation of the impact of environmental policies on private consumption and employment. Relative to the included benefits the feedback effects are large. However, in terms of global effect, the impacts of the feedback are small, compared to the standard GEM-E3 model where the health related benefits are evaluated ex-post.
1. INTRODUCTION
An extensive literature has analysed optimal taxation and tax reform in the presence of externalities in a second-best framework. Most papers assume that environmental quality enters the utility function in a separable way and therefore ignore the feedback effect of environmental quality on the behaviour of the economic agents. The implications of taking into account the feedback effects are considered in Mayeres and Proost (1997, 2001), Schwartz and Repetto (2000) and Williams (2002, 2003).
Mayeres and Proost (1997) derive optimal tax rules in the presence of an externality with a feedback effect for an economy with distortionary taxes. They show that the optimal tax on an externality generating good equals the sum of a revenue-raising component and the net social Pigouvian tax. The net social Pigouvian tax takes into account the damage imposed by the externality on consumers and producers. It will be smaller if a higher level of the externality leads to more consumption of the taxed commodities. Williams (2002) demonstrates that the welfare effect of an externality tax consists not only of a tax interaction and revenue recycling effect, two well-known effects, but also of a benefit side tax interaction effect. Williams considers four possible routes through which air pollution may affect the pre-existing distortions. First, if improved air quality leads to less medical spending, this creates an income effect that reduces labour supply, thereby worsening existing distortions. Secondly, if better air quality reduces time lost to illness, the benefit side tax interaction effect is ambiguous. Thirdly, when cleaner air leads to higher labour productivity, labour supply is boosted and the existing distortions are mitigated. Finally, if a cleaner environment improves the productivity of a fixed factor, the benefits of the externality tax are reduced.
The aim of this paper is to explore by means of a computable general equilibrium (CGE) model to what extent it is important to include the feedback effects of air pollution in policy assessment compared to considering only an ex-post evaluation. For this we use the GEM-E3 model (1), a CGE model for the European economy that covers the interaction between the economy, the energy system and the environment.
Though many CGE models aiming at evaluating environmental policies consider only the costs of environmental policy measures, in the standard GEM-E3 and some other CGE models, the benefits of environmental policies are modelled, through an index of environmental quality that depends on emissions and that provides an ex-post contribution to the consumers' welfare. In this paper we explore how the health related benefits of environmental policies can be modelled in a more realistic way in GEM-E3 and what are the implications for the welfare evaluation of environmental policies. A similar exercise for Thailand is presented by Chung-Li (2002), who explores the economy-wide repercussions of improved air quality through its effect on labour supply and medical expenditure. The main contribution of our analysis is threefold: the inclusion of several routes through which air pollution affects the economic agents, a more encompassing endogenisation of these effects, and the inclusion of the endogenous effects in a large scale and well-established CGE model.
Section 2 first presents the general characteristics of the standard GEM-E3 model, and then discusses how the model is extended to take into account a number of feedback effects of air pollution. This extension concentrates on the health impacts of air pollution as they are the largest gain from an improvement in air quality. The effects of air pollution on vegetation, materials and visibility are still taken into account ex-post (2). Within the health impacts, we distinguish the impact on medical spending by the consumers and the public sector, the impact on the available time of the consumers and the impact on labour productivity. Thus our analysis considers three of the four sources of the benefit side tax interaction effect presented by Williams (2002). We use a health production function which relates a continuous health variable to pollution and the consumption of medical care. This approach is most appropriate for modelling the morbidity effects of air pollution. A realistic treatment of the mortality impacts would require modelling health states rather than a continuous health variable (see, e.g., Freeman (2003)). Since it is less straightforward to integrate this in GEM-E3, we focus on the morbidity effects, while the mortality impacts continue to be modelled in the traditional way, i.e. ex-post, except for the medical costs related to them. Moreover, it is not evident to translate the total marginal willingness-to-pay for a reduction in mortality as derived from stated preference studies in terms of consumption, leisure and available time, as is required in our framework.
In Section 3 the standard and modified GEM-E3 model are used to simulate the effects of a domestic C[O.sub.2] tax in the EU countries. Since a C[O.sub.2] policy has side effects on the emissions of local pollutants, the exercise enables us to explore the extent to which the welfare evaluation of a C[O.sub.2]...
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