Trade,environment, and income inequality: An optimal taxation approach

In a small open economy, how should a government pursuing both environmental and redistributive objectives design domestic taxes when redistribution is costly? And how does trade liberalization affect the economy's levels of pollution and inequalities, when taxes are optimally and endogenously adjusted? Using a general equilibrium model under asymmetric information with two goods, two factors (skilled and unskilled labor), and pollution, this paper characterizes the optimal mixed tax system (nonlinear income tax and linear commodity and production taxes/subsidies) with both production and consumption externalities. While optimal income taxes are not directly affected by environmental externalities, conditions are derived under which under‐ or over‐internalization of social marginal damage is optimal for redistributive considerations. Assuming that redistribution operates in favor of the unskilled workers and that the dirty sector is intensive in unskilled labor, simulations suggest that trade liberalization involves a clear trade‐off between the reduction of inequalities and the control of pollution when the source of externality is only production; this is not necessarily true with a consumption externality. Finally, an increase in the willingness to redistribute income toward the unskilled results paradoxically in less pollution and more income inequalities.     

Endogenous trade policy in general equilibrium: An interaction of redistribution rule,trade openness,and labor market condition

Using a general equilibrium framework, the paper derives trade policy endogenously for a small country. It shows that, contrary to the existing literature, a lobbying industry is not guaranteed trade protection; it may even face trade taxes. Besides lobbying, trade policy depends on other factors such as the trade revenue distribution rule, income distribution across groups, trade openness, factor substitutability in production, industry employment size, and labor market flexibility. The paper also shows that the observed phenomenon of government preference for import tariffs over export subsidies—a long overdue puzzle—is an inherent outcome of lobbying equilibrium. It also shows that trade policies such as import tariffs and export taxes that have the same impact on economic market—Lerner symmetry (1936)—are driven by the same forces in the political market.     

TARIFF FORMATION IN A MULTIDIMENSIONAL VOTING MODEL*

The theory of endogenous trade policy formation argues that tariffs emerge from the political process. This occurs because of conflicting economic interests trying to redistribute income in their favor through the adoption of suitable trade policies. Mayer and Riezman (1987) questioned this view arguing that if individuals differ only in factor ownership they would always prefer some tax/subsidy policy to tariffs. Here we allow individuals to differ not only with respect to factor ownership, but also with respect to consumption preferences and income tax treatment. We show that tariffs might be the social decision even though nobody's individual preferences suggest tariffs as the best choice.     

Economic integration and tax policy with endogenous foreign firm ownership

This paper analyses the impact of economic integration on tax policy in a model where corporate taxation is motivated by the desire to tax profits accruing to foreigners and the number of foreign owned firms is endogenous. Increasing economic integration is modeled as a decline in trade costs or tariffs. It turns out that declining trade costs lead to increasing profit taxes if the government may use import tariffs. If tariffs are not available, declining trade costs induce profit taxes to decline as well. A mandatory reduction in tariffs also triggers profit tax reductions. We conclude that the existence of foreign firm ownership may fail to prevent profit taxes from declining as economic integration proceeds.     

VOTER PREFERENCES FOR TRADE POLICY INSTRUMENTS*

We analyze voter preferences for tariffs and production subsidies. The distribution of tax revenues argument shows that voters with high direct tax burdens prefer tariffs to subsidies. The uncertainty argument demonstrates that if actual tariff and subsidy rates are chosen from the set of individually optimal rates then the range of tariff rates is smaller than the range of subsidy rates. Thus, tariffs might be preferred even though they are less efficient. Finally, the large country argument shows that if a country is large then voters whose income shares decline with more protection prefer tariffs to subsidies.     

Do inward looking trade policies affect poverty and income inequality? Evidence from Indonesia's recent wave of rising protectionism

Unlike previous studies which often focus on trade liberalisation, this paper examines the impact of protectionism in the form of import tariffs and mineral export taxes on rural and urban poverty and income inequality for the first time. Using a dynamic computable general equilibrium model on Indonesia, mineral export taxes were found to adversely affect urban and rural poverty but income inequality hardly changed as the decline in income in the higher income group is not significantly different to the decline in low income groups. However, if smelters for mineral ore are developed, then there is not only a fall in poverty, more so for the rural than urban, but there is some decline in income inequality. On the other hand, although the current imposed import tariffs do not affect poverty or income inequality, any further increases from the current low average MFN applied rates, will see a rise in rural and urban poverty and income inequality. By and large, any small improvements in the trade balance brought upon by the mineral tax and import tariffs are more than outweighed by the substantial decline in real household consumption expenditure due to falls in employment and wages, thereby leading to a fall in GDP growth.     

Unions, progressive taxes, and education subsidies

Progressive income taxes moderate distortionary wage demands by trade unions and thereby reduce unemployment, and at the same time underlie disincentives to acquire skills and decrease labour productivity. Governments can respond by combining progressive taxes with subsidies to investment in human capital. A system of generous education subsidies and steep progressive tax rates is more likely to emerge, the greater the market power of trade unions and the better the ability of governments to influence private education decisions. Empirical analysis for several OECD countries provides results consistent with these propositions. A policy mix of high education subsidies and relatively progressive income taxes is found in countries where union membership is significant.     

Border tax adjustments and tariff‐tax reforms with consumption pollution

We develop a model of a small open economy, where pollution per unit of consumption between domestically produced and imported quantities of the same good differs. We show that the first‐best policy combination calls for consumption taxes on all polluting goods, and border tax adjustment (BTA) measures, that is, tariffs or import subsidies. We identify conditions under which well‐known tariff‐tax reform policies for developing economies, such as a consumer‐price‐neutral piecemeal reform of trade and a consumption tax, and a consumer‐price‐neutral reform of all trade and consumption taxes improve welfare. We also evaluate whether reforms of trade taxes alone are superior to consumer‐price‐neutral reforms of trade and consumption taxes.     

Public policies,pressure groups,and dead weight costs

This paper presents a model of competition among special interest groups for political influence. Each active group exerts pressure to affect its taxes and subsidies, where activities of different groups are related by the equality between total tax collections and total tax subsidies. The dead weight costs and benefits of taxes and subsidies play a major role in our model. An increase in the dead weight cost of taxation encourages pressure by taxpayers, while an increase in the dead weight costs of subsidies discourages pressure by recipients. Various applications of the analysis are discussed.     

The incidence of import liberalization with and without a value added tax: an application to bangladesh

This paper examines the impact of import tariffs and tariff-replacing indirect taxes on the welfare of households grouped by the size distribution of income. A computable general equilibrium model for Bangladesh is simulated to examine the removal of quantitative restrictions and tariffs as well as the replacement of trade taxes with a value added tax (VAT). Import liberalization alone expands the manufacturing sector and increases the welfare of lower income households. If a uniform VAT is placed on both imports and all non-agricultural production in order to replace the lost tariff revenue for the government, some of the gains from import liberalization are diminished. If exports are exempted from the VAT, the gains are sustained to a greater degree. With a combination of tariff liberalization, quota markups, and the VAT, the economy goes through a contraction and the welfare of all households is reduced.     

ARE EFFICIENCY IMPROVEMENTS IN GOVERNMENT TRANSFER POLICIES SELF-DEFEATING IN POLITICAL EQUILIBRIUM?*

This paper studies an election game between two politicians, in which each provides income transfers to special-interest groups in return for political contributions. It is shown that a move to a more inefficient form of transfers may lower the total excess burden created by these transfers, because the politicians are induced to reduce their provision of transfers. For the case in which the income transfers are indirectly provided as trade protection to import-competing industries, a switch from production subsidies to tariffs as the form of protection reduces the equilibrium level of excess burden and makes both politicians better off.     

TAX-PRICE REFORM WITH DIRECTLY UNPRODUCTIVE PROFIT-SEEKING (DUP) ACTIVITIES*

This paper explores the extent to which insights available from existing writings on directly unproductive profit-seeking (DUP) activities in international trade modify rules of tax and tariff reform in normative public economics and examines in what way these should affect advice on tax policy usually given to developing countries. The analysis proceeds by developing two models. The first incorporates revenue seeking directly into a standard open economy public finance model and examines whether analysis of policy reform and economic costs of distortionary tariffs must be modified. The second includes a political component in the form of lobbying for subsidies – the expenditure side of the budget – as well as a normative economic component that raises taxes – the revenue side – to finance the social costs of such lobbying. The model can be used to determine the effects of politically determined expenditures on tax setting. The analysis shows that the grammar of welfare-theoretic arguments that underlies the reform and design of tax and tariff structures is robust to the inclusion of DUP activities of the type considered here. In particular, the latter lend no presumption in favor of uniformity in tax and tariff structures. It is argued that existing policy advice on tax and tariff reform derived from models where DUP activities have traditionally played no role continues to be appropriate when account is taken of formal treatments of DUP-type phenomena extant in the current literature.     

Equity,efficiency, and the structure of indirect taxation

Optimal tax formulae are derived and optimal tax rates calculated for the case where there are many consumers, an income tax is impossible and the government has to trade off efficiency in order to improve the real distribution of income. Consistent aggregation assumptions are used to permit the derivation of simple tax rules depending only on the behaviour of the average consumer and of a socially representative consumer. Calculations for the U.K. in 1972 show how subsidies and taxes vary with the government's revenue requirement and with the degree of egalitarianism in the social welfare function.     

Frontiers of Climate Change Economics

The potential of taxes to correct environmental externalities has long been recognized among economists. Yet, this welfare-enhancing policy commonly faces strong opposition by citizens. Conversely, externality-correcting subsidies frequently enjoy high public support. We conduct a lab experiment to explore public support for Pigouvian taxes and subsidies. In an experimental market with a negative externality, participants vote on the introduction of Pigouvian taxes and subsidies under full or reduced information concerning how the tax revenues will be spent and the subsidy paid for. Theoretically the two instruments should produce identical outcomes. However, we find substantially greater support for subsidies than for taxes. This can partially be explained by the participants’ expectation that the subsidy will increase their own payoffs more than a tax, but not because it is expected to be more effective in changing behavior. Furthermore, we find that with greater uncertainty, the preference for subsidies is even stronger, a result which is consistent with loss aversion.     

The optimal public employment policy

This paper studies optimal public employment in a model with two types of labor, unskilled and skilled, and a single consumption good. A linear income tax is used to redistribute income. It is shown that, if the income tax and public employment levels are optimal, then there is less unskilled labor and more skilled labor in public production than is necessary to minimize costs at the prevailing gross wage rates. The robustness of this result is investigated by examining a second model.     

Multilateral Reforms of Trade and Environmental Policy

The paper analyzes environmental tax policy reform using a competitive model of world trade that includes production‐generated environmental damage (pollution) and trade tariffs. The authors examine the feasibility of Pareto‐improving multilateral reforms of environmental taxes, and show that any environmental tax reform that is mutually welfare‐improving when compensating lump‐sum transfers are assumed is also welfare‐improving when a suitable tariff reform (but no transfers) is combined with the tax changes. Several specific reform proposals are developed. These results expand the feasible set of mutually improving policy proposals for international policy initiatives.     

Inequality and the Relative Reliance on Tariffs

In this paper we uncover the existence of a U-shaped relationship between inequality and the relative reliance on tariff revenue, by estimating a cross-sectional regression relating the ratio of the tariff rate over the tax rate to inequality and a set of control variables such as GDP per capita, openness, the degree of democracy, and area dummies. We explain this U-shaped relationship by means of a Ricardian model of trade in vertically differentiated products between a developing country and the (developed) rest of the world. The model generates the U-shaped relationship because the preferences of the political majority (as captured by the median voter model) are shaped not only by the influence of inequality on the desire for redistribution, but also by the influence of inequality on the relative size of the tax base on which income taxes and tariffs are applied.     

Optimal Taxation of Risky Human Capital*

In a two‐period life‐cycle model with ex ante homogeneous households, earnings risk, and a general earnings function, we derive the optimal linear labor tax rate and optimal linear education subsidies. The optimal income tax trades off social insurance against incentives to work. Education subsidies are not used for social insurance, but they are only targeted at offsetting the distortions of the labor tax and internalizing a fiscal externality. Both optimal education subsidies and tax rates increase if labor and education are more complementary, because education subsidies indirectly lower labor tax distortions by stimulating labor supply. Optimal education subsidies (taxes) also correct non‐tax distortions arising from missing insurance markets. Education subsidies internalize a positive (negative) fiscal externality if there is underinvestment (overinvestment) in education because of risk. Education policy unambiguously allows for more social insurance if education is a risky activity. However, if education hedges against labor‐market risk, optimal tax rates could be lower than in the case without education subsidies.     

The importance of government commitment in attracting firms: A dynamic analysis of tax competition in an agglomeration economy

Agglomeration tendencies of industrial firms significantly affect the nature of tax competition. This paper analyzes tax competition between two countries over an infinite time horizon in an economy with trade costs and internationally mobile industrial firms. Most of the previous studies on tax competition in the ‘new economic geography’ framework employ static models. In this study, two governments dynamically compete with each other to attract firms through their choices of taxes and subsidies. It is shown that the commitment of the governments to their policies is crucial in determining the distribution of firms in the long run. Specifically, if governments find each others׳ tax policies credible, then one country will attract all the firms when trade costs are low enough to make agglomeration forces dominant. If policies are not credible, both countries may attract an equal share of firms even when trade costs are low, as the lack of commitment by governments acts as a dispersion force.     

Export taxes versus buffer stocks as optimal export policies under uncertainty

Optimal state-dependent export taxes and costly-to-store buffer stocks are compared in their welfare implications for an exporter possessing monopoly power in the international trade of a volatile commodity. Optimal stochastic control is used to derive the optimal buffer stock rules. It is shown that, if the internal and external fluctuations facing the exporter are large, if the storage costs are low, and if the price elasticity of export supply is small relative to that of export demand, the exporter would gain more from a buffer stock than from a optimal export tax. World welfare is always increased by buffer stocks, as opposed to tariffs; and, under some conditions, the foreign country might also benefit and, hence, not retaliate.