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Executive Summary

Employment, Environmental Taxes, and Income Taxes

February 2000
By Nada Eissa, Richard Blundell, and Laura Blow

In "Employment, Environmental Taxes and Income Taxes," Eissa, Blundell, and Blow examine the relationship between environmental taxes and labor markets. The paper is written for economists. It finds that theoretical modeling and empirical labor supply literature, to date, do not establish clearly whether using revenue from a new environmental tax to reduce an existing tax on labor income would increase, decrease, or have no impact at all on employment.

This kind of environmental tax reform (ETR) has been widely discussed in policy circles. Many European countries are moving in this direction, perhaps because their economies have much higher levels of unemployment than the U.S. economy. The authors summarize the economic literature relevant to this type of ETR, and provide a number of important insights for future researchers in this area to consider.

Theoretical Review

The idea of a "double dividend" has been discussed extensively in the economic literature. One of the dividends is an improvement in environmental quality. The second dividend varies. Sometimes it is an improvement in the well-being of people (what economists call "social welfare"), ignoring the environmental benefit. Sometimes the second dividend is an increase in total wages in the economy, or some other measure of total employment in the economy. Sometimes, the theoretical model has been constructed so that more work or higher wages is synonymous with improved well-being, but this is not necessarily the case. In some cases, working fewer hours would be better for workers and society.

The theoretical literature's basic lesson is that double dividends of either type are possible, but not so easy to obtain as some of the earlier writings on this topic suggested. This is because the final incidence of the environmental tax, that is, its comprehensive effect on prices, is of critical importance. Taxes on things other than labor (e.g., gasoline) can be implicit taxes on labor. Under some circumstances, the purchasing power of after tax wages can actually decline even when all revenue from the environmental tax is returned to workers. A decline in purchasing power means that even though income went up, less gasoline (for example) can be purchased because the price of gasoline rose even more. But whether purchasing power rises or falls from an ETR in the real world is an empirical question, discussed below.

Empirical Literature

A review of the empirical literature for the European economy finds macroeconomic models that yield some promising results for ETRs that lower labor taxes. Environmental tax revenues of about one percent of GDP used to reduce taxes on labor yield employment increases of 0.1 to 0.7 percent above what each model predicts will occur without this type of policy (the model baseline). The results also suggest that reductions of employer's social security taxes generate stronger employment effects (relative to baseline projections) than income tax reductions.

The authors find that the empirical literature for the US economy contains essentially no explicit evaluation of the labor market effects of this type of ETR, either macroeconomic or microeconomic. Therefore, they discuss the relevant aspects of the US labor supply literature, focusing on business' choices to hire workers and workers' choices to work more or fewer hours. For example, they point out that the empirical literature suggests that payroll tax cuts in the US would mostly increase after-tax (take-home) wages rather than significantly decreasing what employers pay workers (i.e., before-tax wages). This means that the job creation incentive for businesses of a reduction of the payroll tax might be small or even negligible.

Which point of view is correct? That is, does ETR of this type increase employment, have negligible effects, or decrease employment? It is possible that the positive results in European macro-economic models depend on European macro-economic conditions that do not exist in the US (e.g., higher levels of structural unemployment and much less flexible wage rates). It is also possible that businesses in the U.S. would add jobs or increase wages more than the usual labor supply study suggests. Some business organizations -- especially those that represent small business - have claimed for years that academic analyses of this type are incorrect, and that they would hire many more workers or increase the wages they pay if the employer's portion of the payroll tax (7.65 percent of wages) were decreased.

In sum, the authors review existing economic literature and raise important issues that future studies of an ETR's effect on employment should incorporate.

Note: Executive Summary prepared by Brian Parkinson and Gary Wolff.

If you are also interested in learning more about how ETR would affect capital accumulation in the United States, please read the "Effects of Environmental Tax Shifting on U.S. Capital Formation" by William Gale and Kevin Hassett.

Download "Employment, Environmental Taxes, and Business Taxes" (58 pp. / 243 kb)