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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

601-B Carolyn Avenue Austin, TX 78705 703-869-6951 west.garrett@gmail.com

June 2, 2007

Dr. A. Gill
Editor-in-Chief,
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

601-B 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 closed-form 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 coal-producing 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 three-factor 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 Fullerton-Heutel 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 = RX

Y = Y ( RY , Z )

where X is the clean good, Y is the dirty good, and R X and RY are clean inputs into production,

or “resource” inputs representing either labor or capital. The resource constraint is the

following:

R X + RY = R [1.1]

where R is the fixed total amount of resources in the economy. Totally differentiating this

constraint yields:

Rˆ X λ RX + Rˆ Y λ RY = 0 [1.2]

where a hat denotes a proportional change ( Rˆ X ≡ dR X / R X ), and λij denotes sector j ’s share of

factor i (e.g. λ RX ≡ RX / 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 RY and Z depending on their respective factor prices, pR and pZ , and according to the

elasticity of substitution in production, σ Y (FH). The differentiation of σ Y using its definition

yields

Rˆ Y − Zˆ = σ Y ( pˆ Z − pˆ R ) [1.3]
 7

where σ Y is positive by definition. The firm’s resource cost is pR = 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 pZ = τ Z .

Differentiating these equations and defining τˆZ ≡ dτ Z / τ Z yields

pˆ R = rˆ [1.4]

pˆ Z = τˆZ [1.5]

Then substituting [1.5] and [1.4] into [1.3] yields the following equation:

Rˆ Y − Zˆ = σ Y (τˆZ − rˆ) [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:

pˆ X + Xˆ = rˆ + Rˆ X [1.7]

pˆ Y + Yˆ = θYR (rˆ + Rˆ Y ) + θYZ ( zˆ + τˆZ ) [1.8]

where θYR ≡ r ⋅ RY / pY ⋅ Y is the share of sales revenue of sector Y paid to resources, and p X and

pY are output prices. Also, θYZ ≡ τ Z ⋅ Z / pY ⋅ Y is the share of revenue of sector Y paid for

pollution, in the form of taxes. Since these ratios are shares, thenθYR + θYZ = 1 .

Totally differentiating each sector’s production functions, and substituting in the

conditions for perfect competition, yields the following equations:

Xˆ = Rˆ X [1.9]

Yˆ = θYR RˆY + θYZ Zˆ [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):

Xˆ − Yˆ = σ U ( pˆ Y − pˆ X ) [1.11]

Equations [1.2], [1.6]-[1.11] are seven equations in eight unknowns ( Rˆ X , RˆY , Zˆ , rˆ, pˆ X , pˆ Y , Xˆ , Yˆ ).

In order to eliminate one equation, good X becomes the numeraire good, so that p X = 1

and pˆ X = 0 . Therefore, this system of seven equations provides the general equilibrium

solutions to all seven unknowns as functions of the parameters and the exogenous increase in the

pollution tax ( τˆZ >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 R̂ X and R̂Y ,

since this paper also examines how the pollution tax affects labor supply (i.e. when R is labor),

when workers face adjustment costs. Finally, this paper omits the explicit solutions for X̂ and Yˆ .

This paper derives the following solutions to the general model:

pˆ Y = θYZτˆZ [1.12a]

rˆ = 0 [1.12b]

(σ (1 + θYRγ R ) + σ U θYZ γ R )
Zˆ = − Y τˆZ [1.12c]
1+ γ R

θ (σ − σ Y )
Rˆ X = YZ U τˆZ [1.12d]
1+ γ R

γ θ (σ − σ U )
Rˆ Y = R YZ Y τˆZ [1.12e]
1+ γ R
 9

where γ R ≡ λRX / λ RY . The net return to investors on the resource input does not change because

the clean good X uses a one-for-one 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 pY 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 , p̂Y , is also positive and depends on the share of pollution in the dirty

sector. On the contrary, Ẑ 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

Ẑ 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.

For both R̂ X and R̂Y , the sign and the magnitude of each quantity change depend on the

two elasticities of substitution. In the Cobb-Douglas 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 R̂ X is negative, and R̂Y is positive.

II. MODEL WITH CAPITAL ADJUSTMENT COSTS FOR THE FIRM

A. General Model with Non-Linear 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 ϕ ( Kˆ 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,

and that the depreciation rate is sufficiently large to allow for no costs of adjustment when K̂ X

or K̂ 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.

Kˆ X , Kˆ 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:

Xˆ = Kˆ X − ϕ ( Kˆ X ) [2.9]

Yˆ = θYK Kˆ Y + θYZ Zˆ − ϕ ( Kˆ Y ) [2.10]

 11

where the adjustment cost ϕ is a non-linear 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:

pˆ Y = θYZτˆZ + ϕ ( Kˆ Y ) − θYK ϕ ( Kˆ X ) [2.12a]

rˆ = −ϕ ( Kˆ X ) [2.12b]

(θ γ (σ − σ U ) + σ Y + γ K ) (γ (1 − σ U )) (σ U θYZ γ K + (1 + θYK γ K )σ Y )
Zˆ = −ϕ ( Kˆ X ) YK K Y + ϕ ( Kˆ Y ) K − τˆZ
1+ γ K 1+ γ K 1+ γ K

(1 − σ U θYK − σ Y θYZ ) (1 − σ U ) (θYZ (σ U − σ Y ))

Kˆ X = ϕ ( Kˆ X ) − ϕ ( Kˆ Y ) + τˆZ
1+ γ K 1+ γ K 1+ γ K

(γ (σ θ + σ YθYZ − 1)) γ (1 − σ U ) (γ KθYZ (σ Y − σ U ))

Kˆ Y = ϕ ( Kˆ X ) K U YK + ϕ ( Kˆ Y ) K + τˆZ
1+ γ K 1+ γ K 1+ γ K

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 closed-form solutions.

Nonetheless, one can still interpret these solutions to the general non-linear adjustment costs

case. In Equation [2.12b], the change in the rate of return to capital owners is no longer always

zero. Since ϕ ( Kˆ X ) is positive when K̂ X is positive, the change in the rate of return is potentially

negative. From Section I, when K̂ X is positive, K̂ Y is negative. For this particular case, ϕ ( Kˆ Y )

is zero since firms do not incur adjustment costs when the change in the capital stock is negative.

When K̂ 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 pY falling, but firms and capital

owners lose.

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

that because all three terms on the right-hand side for K̂ X and K̂ Y are opposite in sign, then K̂ X

and K̂ Y must have opposite signs, meaning that firms in one sector incur adjustment costs of

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 Cobb-Douglas. By examining the further special case when both of these

elasticities are unity, one finds that no capital moves across sectors (i.e. K̂ X and K̂ 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: ϕ ( Kˆ X ), ϕ ( Kˆ Y ) are Linear

 13

The paper now considers the case when the adjustment costs are linear1. Thus, the

adjustment costs follow the functional form that ϕ ( Kˆ X ) = ϕ ⋅ Kˆ X , and ϕ >0 when K̂ X is positive,

and ϕ =0 otherwise. As shown in an Appendix, with linear adjustment costs, the results are as

follows:

ϕ[(σ Y − σ U )(θYZ (γ K + σ Y ϕ ))]

rˆ = τˆZ
(γ K + σ Y ϕ ){1 + θYK γ K + ϕ[σ U (θYK + γ K ) − (1 + γ K )] + θYZ (γ K + σ Y ϕ )}

θYZ (γ K + σ Y ϕ ){1 + θYK γ K − ϕ (1 + γ K ) + θYZ (γ K + σ Y ϕ )} + ϕ[σ Yθ YZ (γ K + σ Y ϕ )(θYK + γ K )]

pˆ Y = τˆZ
(γ K + σ Y ϕ ){1 + θYK γ K + ϕ[σ U (θYK + γ K ) − (1 + γ K )] + θYZ (γ K + σ Yϕ )}

− {σ U θYZ (γ K + σ Y ϕ ) + σ Y (1 + θYK γ K + ϕ[σ U (θYK + γ K ) − (1 + γ K )])}

Zˆ = τˆZ
1 + θYK γ K + ϕ[σ U (θYK + γ K ) − (1 + γ K )] + θ YZ (γ K + σ Y ϕ )

− [(σ Y − σ U )(θ YZ (γ K + σ Y ϕ ))]

Kˆ X = τˆ
(γ K + σ Y ϕ ){1 + θYK γ K + ϕ[σ U (θ YK + γ K ) − (1 + γ K )] + θYZ (γ K + σ Y ϕ )} Z

γ K [(σ Y − σ U )(θYZ (γ K + σ Y ϕ ))]

Kˆ Y = τˆZ
(γ K + σ Y ϕ ){1 + θYK γ K + ϕ[σ U (θYK + γ K ) − (1 + γ K )] + θYZ (γ K + σ Y ϕ )}

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

sector is greater, then K̂ X is negative, and ϕ ( Kˆ X ) is zero by assumption, so as a result, r̂ 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 closed-form 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 Non-Linear 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

assumes that workers only experience adjustment costs when firms lay them off (i.e., when L̂X

and L̂Y are negative). The worker adjustment costs may include the following possibilities:

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 one-time 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 laid-off 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:

Lˆ X λ LX + LˆY λ LY + Ψ ( Lˆ X ) + Ψ ( LˆY ) = 0 [3.2]

where Ψ ( Lˆ X ), Ψ ( LˆY ) 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 = θYZτˆZ [3.12a]

wˆ = 0 [3.12b]

Ψ ( Lˆ X ) + Ψ ( LˆY ) [σ Y (1 + θ YLγ L ) + σ U θYZ γ L ]

Zˆ = − − τˆZ [3.12c]
λ LY (1 + γ L ) 1+ γ L

Ψ ( Lˆ X ) + Ψ ( LˆY ) [θYZ (σ U − σ Y )]
Lˆ X = − + τˆZ
λ LY (1 + γ L ) 1+ γ L

Ψ ( Lˆ X ) + Ψ ( LˆY ) [γ LθYZ (σ U − σ Y )]
LˆY = − − τˆZ
λLY (1 + γ L ) 1+ γ L

where ŵ 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 Ψ ( Lˆ X ) and

Ψ ( LˆY ) are both equal to zero, then the equilibrium reduces to the FH result. Since the

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 ŵ and p̂Y 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 τˆZ , 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

Case 1: Ψ ( Lˆ X ), Ψ ( LˆY ) are linear. When the adjustment costs are linear, the functional

form is Ψ ( Lˆ X ) = ΨLX ⋅ Lˆ X when L̂X is negative, and ΨLX =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

[σ ( λ + ΨLY + θYL (λ LX + ΨLX )) + σ U θYZ (λ LX + ΨLX )]

Zˆ = − Y LY τˆZ
λLY + ΨLY + λLX + ΨLX

[θ (σ − σ Y )(λLY + ΨLY )]
Lˆ X = YZ U τˆZ
λLY + ΨLY + λLX + ΨLX

[θ (σ − σ U )( λLX + ΨLX )]
LˆY = YZ Y τˆZ
λ LY + ΨLY + λLX + ΨLX

where ΨLX and ΨLY are the linear adjustment costs in the clean and dirty sectors, respectively.

Again, the result is Ẑ <0, and the sign of Lˆ X , LˆY strictly depends on which elasticity of

substitution is greater. In the Cobb-Douglas 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, ΨLX = 0 . From these closed-form

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 ΨLX = 0 . The

key finding from this example is that the negative double difference change in L̂Y is larger in

absolute value than the positive double difference change in L̂X , 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: Ψ ( Lˆ X ), Ψ ( LˆY ) are quadratic. The functional form of the quadratic adjustment

costs follows that of Cahuc and Zylberberg (2004): Ψ ( Lˆ X ) = ΨLX ⋅ Lˆ X 2 when L̂X 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 1-3, 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 long-run 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

λ LX γL
This proof uses the notational definitions that = and
λ LX + λ LY 1 + γ L
λLY 1
= and begins with the following results:
λLX + λLY 1 + γ L

[θYZ (σ U − σ Y )(λLY + ΨLY )]

LˆAC
X = τˆZ
λLY + ΨLY + λLX + ΨLX
where the AC stands for the adjustment costs result.
[θ (σ − σ U )(λLX + ΨLX )]
LˆYAC = YZ Y τˆZ
λLY + ΨLY + λ LX + ΨLX

θYZ (σ U − σ Y )λLY
LˆFH
X = τˆZ
λ LX + λLY

θYZ (σ Y − σ U )λLX
LˆFH
Y = τˆZ
λLX + λLY

In the case when σ U > σ Y , the result is Lˆ X > 0 , and then by assumption ΨLX = 0 . Thus,

λLY λLY + ΨLY − λLX ΨLY

LˆFH ˆAC
X − LX = − =
λLX + λ LY λLX + λ LY + ΨLY ( λLX + λLY )(λLX + λ LY + ΨLY )

⇒ Lˆ FH ˆ AC
X < LX

In addition,

1 1 ΨLY
LˆFH ˆAC
Y − LY = − =
λLX + λ LY λLX + λ LY + ΨLY ( λLX + λLY )(λLX + λ LY + ΨLY )

⇒ LˆYFH > LˆYAC

Next, take the absolute values of these two inequalities. Since λ LX < 1 , then the model with

adjustment costs has a larger net loss in labor supply than the FH result.
 22

References

Adda, Jerome, and Russell Cooper. 2003. Dynamic Economics: Quantitative Methods and
Applications. Cambridge, Massachusetts and London, England: MIT Press.

Cahuc, Pierre, and Andr Zylberberg. 2004. Labor Economics. Cambridge, Massachusetts and
London, England: MIT Press.

Fullerton, Don, and Garth Heutel. 2005. “The General Equilibrium Incidence of Environmental
Taxes.” National Bureau of Economic Research, Working Paper No. 11311 (May).

Fullerton, Don, and Gilbert Metcalf. 2001. “Environmental Controls, Scarcity Rents, and Pre-
existing Distortions.” Journal of Public Economics 80 (2): 249-267.

Fullerton, Don, and Gilbert Metcalf. 2002. “Tax Incidence.” In Handbook of Public
Economics, Vol. 4, eds. A. Auerbach, and M. Feldstein. Amsterdam: Elsevier, 1787-
1872.

Goulder, Lawrence H., and Lawrence H. Summers. 1989. “Tax Policy, Asset Prices, and
Growth: A General Equilibrium Analysis.” Journal of Public Economics 38 (Sep.): 265-
296.

Hamermesh, Daniel S. 1989. “Labor Demand and the Structure of Adjustment Costs.”
American Economic Review 79 (Sep.): 674-689.

Hamermesh, Daniel S., and Gerard A. Pfann. 1996. “Adjustment Costs in Factor Demand.”
Journal of Economic Literature 34 (Sep.): 1264-1292.

Harberger, Arnold C. 1962. “The Incidence of the Corporation Income Tax.” Journal of
Political Economy 70 (3): 215-240.

Koeppel, Barbara. Sunday, September 5, 1993. “For Airline Workers the Crash Can Be Fatal.”
Washington Post: C,1:1. In Fullerton, Don. 2001. “A Framework to Compare
Environmental Policies.” Southern Economic Journal 68 (2): 224-248.

Jacobson, Louis S., Robert J. LaLonde, and Daniel G. Sullivan. 1993. “Earnings Losses of
Displaced Workers.” American Economic Review 83 (Sep.): 685-709.

Summers, Lawrence H. 1981. “Taxation and Corporate Investment: A q-Theory Approach.”

Brookings Papers on Economic Activity 1981 (Jan.): 67-127.
Figure 1
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Figure 2
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Figure 3
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Table 1

Table 1: Parameter Values Chosen for Section III. B. Case 2

θ YL = 0.75
θYZ = 0.25
σU = 1
λLX = 0.8
λLY = 0.2
Ψ = 1.2