No 26/2004 Can a carbon permit system reduce Spanish unemployment? Taran Fæhn, Antonio G. Gómez-Plana and Snorre Kverndokk

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1 MEMORANDUM No 26/2004 Can a carbon permt system reduce Spansh unemployment? Taran Fæhn, Antono G. Gómez-Plana and Snorre Kverndokk ISSN: Department of Economcs Unversty of Oslo

2 Ths seres s publshed by the Unversty of Oslo Department of Economcs P. O.Box 1095 Blndern N-0317 OSLO Norway Telephone: Fax: Internet: e-mal: econdep@econ.uo.no In co-operaton wth The Frsch Centre for Economc Research Gaustadalleén 21 N-0371 OSLO Norway Telephone: Fax: Internet: e-mal: frsch@frsch.uo.no No 25 No 24 No 23 No 22 No 21 No 20 No 19 No 18 No 17 No 16 Lst of the last 10 Memoranda: Kjell Arne Brekke and Karne Nyborg Moral hazard and moral motvaton:corporate socal responsblty as labor market screenng. 32 pp. Alexander W. Cappelen and Bertl Tungodden Local autonomy and nterregonal equalty. 24 pp. Jo Thor Lnd Does permanent ncome determne the vote?. 32 pp. Erk Børn, Terje Skjerpen and Knut R. Wangen Can Random Coeffcent Cobb-Douglas Producton Functons Be Aggregated to Smlar Macro Functons?. 31 pp. Atle Seerstad Open mappng theorems for drectonally dfferentable functons. 13 pp. Contract Renewal Helge Holden, Lars Holden, and Stenar Holden. 44 pp. Jo Thor Lnd Repeated surveys and the Kalman flter. 19 pp. Kar Eka When qualty today affects servce needs Tomorrow. 30 pp. Rolf Golombek and Mchael Hoel Unlateral emsson reductons when there are cross -country technology spllovers. 23 pp. Kjetl Bjorvatn and Alexander W. Cappelen Globalsaton, nequalty and redstrbuton. 17 pp. A complete lst of ths memo-seres s avalable n a PDF format at:

3 December 2004 Can a carbon permt system reduce Spansh unemployment? 1 by Taran Fæhn *, Antono G. Gómez-Plana ** and Snorre Kverndokk *** Abstract: Ths paper analyses whether recyclng revenues from carbon emsson permt auctons can reduce unemployment n the Spansh economy. Span's devaton from EU's ntermedate emsson goals s more serous than for most other EU countres, and the unemployment s also well above the EU average. We use a CGE model that ncludes a matchng model wth two types of labour, and whch allows for dfferent prcng rules and returns-to-scale assumptons. We fnd that abatement reduces unemployment due to benefcal mpacts of recyclng the revenue from permt sales. Unemployment s more effectvely abated when revenues are used to reduce labour taxes rather than ndrect taxes. Contrary to other studes of Europe, we fnd that the best opton s to reduce payroll taxes on sklled labour. Ths reform s the most successful both n ncreasng demand and n dampenng the supply response to rsng wages. All the recyclng schemes also generate dvdends n terms of welfare, but none offset the abatement costs entrely. JEL classfcaton: D58, J68, Q38. Keywords: Spansh unemployment; Tax reform; Emsson Permt Auctons; Employment dvdend; Matchng functons; Increasng returns to scale; Computable general equlbrum models. * Correspondng author: Research Department, Statstcs Norway, P.B Dep, 0033 Oslo, Norway. Tel , fax , e-mal: taran.fahn@ssb.no. ** Publc Unversty of Navarre, Department of Economcs, Campus de Arrosadía, Pamplona, Span. Tel , fax , e-mal: agomezgp@unavarra.es. *** Ragnar Frsch Centre for Economc Research, Gaustadalléen 21, 0349 Oslo, Norway. Tel , fax , e-mal: snorre.kverndokk@frsch.uo.no. 1 We are ndebted to comments from Brta Bye, Mchael Hoel and Mguel Rodrguez. We acknowledge fnancal support from the Norwegan Research Councl, from Fundacón BBVA, the Spansh Mnstry of Scence and Technology, through the project BEC , and from Goberno de Navarra.

4 1. INTRODUCTION Span, as part of the EU, has ratfed the Kyoto protocol, whch ams at reducng greenhouse gas emssons n ndustralsed countres by Though the burden sharng agreement wthn EU allows Span to ncrease emssons by 15% n ths perod compared to the 1990 level, a fulflment of the commtment wll requre sgnfcant reductons compared to a busness-as-usual scenaro. In fact, by havng ncreased the carbon doxde (CO 2 ) emssons by 39.4% from 1990 to 2002, Span's devaton from EU's ntermedate emsson goals was more serous than for most other EU countres; see European Envronment Agency (2004). As part of the EU emsson permt program Span wll ntroduce revenue-rasng emsson permts from There s deep concern for the socal costs of such measures. In partcular, the debate has focused on the consequences n terms of lost compettveness and subsequent unemployment. The unemployment problems have been severe snce the last part of the 1970s. By the md 1980s and also by the md 1990s, the unemployment rate exceeded 20%. In 2002, the average rate had decreased to 11%, wth the rate among unsklled labour beng the double of that of sklled. Stll, ths s stll among the hghest unemployment rates n the EU. These facts make Span specal n a European context, and call for detaled studes of ths country and ts nsttutons n order to address the economc consequences of carbon polces. Our am s to explore whether revenues from carbon emsson permt auctons can allevate the serous unemployment problem n the Spansh economy, and how the recyclng should be targeted n order to obtan maxmum effect. The lterature has extensvely addressed the possbltes of a double dvdend from green polces,.e. economc gans n addton to envronmental benefts that may entrely (strong dvdends) or partly (weak dvdends) offset the costs caused by ntroducng green tax wedges. Welfare dvdends may occur f ntroducng green taxes or, equvalently, a free market for emsson quotas, moderates the welfare losses of other, exstng, dstortonary taxes, or t may be obtaned by usng revenues from the green taxaton to reduce such tax wedges. For a recent survey, see Schöb (2003). Dvdends n terms of employment have also been much n focus, especally n the European debate. Mors (1995), Majocch (1996), and Bosquet (2000) all survey quanttatve studes, manly for the EU countres. The costs of green polces are lkely to reduce overall economc actvty and employment, unless tax revenues can be targeted towards cuttng dstortonary taxes on labour. The 2

5 general concluson s that there seems to be postve, though small, employment effects of shftng taxes from labour to energy/envronment. There s also some evdence of hgher employment dvdends f measures are targeted to the low sklled. The reasons are that both demand and supply tend to be more elastc n case of unsklled labour. Such a reform was orgnally proposed as a soluton to the European unemployment problem n Dréze and Malnvaud (1994). However, n a Computable General Equlbrum (CGE) analyss where the EU markets for sklled and unsklled labour are separated, Bosello and Carraro (2001) conclude that the employment effects are larger when taxes are reduced for all labour rather than for the low sklled, only. As ths queston s of specal nterest for Span, n lght of the dstrbutonal aspects of the extraordnarly hgh unemployment of low sklled workers, we nclude these two proposals n our study. In addton, we supply the analyss wth examnatons of two other schemes: Recyclng through reduced VAT rates and through pay roll taxes on sklled labour. In lght of the pessmstc employment results n Bosello and Carraro (2001) of targetng to low sklled labour, targetng to the relatvely sklled s a natural follow-up research ssue. The tendency n the vast model lterature on the double dvdend ssue s to study welfare effects n a CGE framework that leaves out labour market mperfectons, whle addressng employment effects n shorter-term econometrc models wth no consstent measure of welfare changes. In fact, the welfare and employment effects are hghly nterlnked. Results on employment are mportant determnants for the welfare results, both because unemployment represents waste of resources and because hgh labour taxes tend to generate too strong ncentves for (voluntarly) devotng tme to lesure (Bye, 2000). The am of ths paper s to measure welfare and employment effects for the Spansh economy wthn a consstent framework, by applyng a CGE model that ncorporates the specfc labour market characterstcs of Span. Such a combned approach s rare n the lterature, and though ntegrated models of the EU as an entty have been appled (Carraro et al., 1996), the outstandng Spansh case, n detal, s stll not addressed. The scope for employment dvdends, as well as welfare dvdends, depends on the features of the labour markets, n partcular ther flexblty and wage formaton. In many respects Span's labour market nsttutons and unemployment problems are specal. Dolado et al. (1998) stress the relatvely 3

6 hgh weght of unsklled unemployment n Span compared to the EU average. Blanchard et al. (1995) dentfy the man reasons for the hgh unemployment to be the collectve structure of wage barganng combned wth hgh employment protecton for part of the labour force. Bover et al. (2000) also emphasse the role of generous unemployment benefts. In addton, there are large regonal unemployment dfferences, due to a relatvely low moblty of labour across regons. Another common argument s that large wedges between take-home pay and the cost of labour hamper employment. Payroll taxes are hgh n Span (see, e.g., Bajo and Gómez-Plana, 1999), and lowerng the wedges may reduce labour costs and encourage Spansh employment. We represent the mechansms of the Spansh labour market as matchng processes and dstngush between sklled and unsklled workers, due to mportant dfferences n supply and demand, and thus n polcy responses. The labour supply s endogenous, and we are thus able to separate employment effects from adjusted supply behavour and changes n the number of unemployed, respectvely. Matchng processes and msmatch seem to descrbe the Spansh labour markets well, as there s a hghly ntensve matchng process. In 1996, there were more than 8.5 mllon hres out of a labour force of 16 mllons (Castllo et al., 1998). Ths s manly due to a hgh number of workers hred under fxed-term contracts (31.7% n 2001 whle the EU average was 13.4%). These contracts are most promnent among less educated (Tohara, 1996). Low geographcal moblty also causes a sgnfcant msmatch problem. Matchng models can, as well, represent the frctons caused by presence of labour unons. Bosello and Carraro (2001) model the labour market based on assumptons on unon barganng power. Ths s a good approach for some European countres, but as the Spansh labour market s charactersed by a gap between a very low unonsaton rate and the barganng coverage rate (Blau and Kahn, 1999, p. 1418), the unon barganng power approach s less sutable for Span. We follow the matchng specfcaton n Balstrer (2002), whch s a new way of ntroducng equlbrum unemployment n CGE models. Our model also takes nto account that market power s prevalent n several Spansh ndustres, not least n the emsson-ntensve productons of energy and of transportaton (Huergo, 1998). We quantfy the mpact of mperfect competton and ncreasng returns to scale on the results. 4

7 2. METHOD 2.1 The desgn of the analyss We perform our analyss based on smulatons on a large-scale CGE model for the Spansh economy. The man queston posed n ths analyss s whether an employment dvdend can be reaped from establshng a natonal market for carbon permts, gven that the government collects the revenue and recycles t back to the economy. We focus on the role of revenue recyclng n reducng the unemployment rate. Employment dvdends are defned n terms of unemployment rate reductons rather than employment formaton, n order to account for changes n both labour demand and supply. Employment effects are, however, also reported. In addton, we examne possble welfare dvdends of the reforms,.e. gans n welfare exclusve of envronmental effects. These problems are addressed by smulatng reductons n the number of emsson permts from the benchmark level. We present the results of 25 percent reductons. 2 The benchmark prce for permts s zero, but when permts become scarce, frms begn to bd for them and the prce ncreases. Ths can be nterpreted as an open aucton of permts wth a unform prce (or equvalently, carbon taxaton). We smulate fve recyclng alternatves: Case A: Lumpsum transfers to households, Case B: Reduced payroll tax rates for all labour, rrespectve of skll levels, Case C: Reduced ndrect taxes, exemplfed by the VAT rates. Case D: Reduced payroll taxes exclusvely for unsklled labour. Case E: Reduced payroll taxes exclusvely for the sklled. As lumpsum recyclng s, by defnton, undstortonary, the smulaton n Case A s useful for cultvatng the pure effects of ntroducng a prce on emssons (the pure abatement effects). Comparng the other, more polcy-relevant, recyclng cases wth Case A enables us to solate the contrbutons of the recyclng schemes (the recyclng effects). Comparng the dfferent recyclng schemes n Cases B, C, D and E wll llumnate how recyclng should be drected n order to mnmse 5

8 unemployment and reveal to what extent the reforms are assocated wth tradeoffs between welfare and employment dvdends. We close the analyss by nvestgatng the senstvty of our results to model characterstcs and parameter assumptons. Frst, we dentfy how the assumptons of mperfect competton and ncreasng returns to scale matter by comparng the results wth correspondng results from a constant returns to scale model wth perfect competton. Whle many CGE models used n the double dvdend lterature are calbrated to a CRTS model, much emprcal work casts doubt on ths assumpton. Second, we test the senstvty of our results to dfferent estmates of the externalty parameters n the labour market matchng functons, whch should be consdered uncertan. We compare the outcome of usng devatng estmates from two Spansh studes, Burda and Wyplosz (1994) and Castllo et al. (1998). Fnally, we perform a smple test of the mpact of our mperfect labour market assumptons. In order to gve a better ntuton and be able to decompose the results of the large-scale model, a stylsed, reduced form of the model s also presented. The mnature model reflects the major mechansms n the large model and makes them more transparent. The man characterstcs of the numercal model are outlned n secton 2.2. For detals see Appendces 1, 2, and 3. Secton 2.3 derves the mnature model and vsualses t n a 2-equaton dagram. 2.2 The numercal model The numercal model s a statc CGE model, where the man refnements are made n order to capture the relevant welfare and employment outcomes for the Spansh economy of changes n carbon polcy and labour taxaton. In partcular, the model ncorporates mportant features of the Spansh mperfect labour markets, a comprehensve descrpton of the exstng tax structure, mperfect competton and other dstortonary wedges wthn the Spansh economy, as well as dsaggregate structures of household utlty, producton and factor use, n order to represent relevant substtuton possbltes decsve to the polcy responses. The model also computes CO 2 emssons on a detaled level both from frms and households. 2 Smaller, as well as larger, reductons show the same qualtatve results, and all varables react smoothly to the varatons n emsson restrctons. 6

9 Span s modelled as a small, open economy. Goods are dfferentated by orgn (domestc and foregn), accordng to the Armngton assumpton. The balances of trade and fnancal cross-border flows are fxed. Ths avods contnuous net captal flows n or out of the country. All agents, except the publc sector, have optmsng behavour. The am of the publc sector s to balance revenues accordng to an exogenous restrcton, whch we keep constant,.e. all polcy changes are revenue neutral. A macroeconomc restrcton fxes publc nvestment and defct (or surplus), mplyng that publc savngs are, as well, fxed. Revenues from market sales of CO 2 permts are ncluded n the publc ncome. Prmary factor endowments are gven and moble across ndustres, and factor markets clear by adjustments n factor prces. However, the fact that labour markets far from clear n the Spansh economy, s taken care of by allowng for equlbrum unemployment (see below). In macro, savngs are fxed, and nvestments and savngs balance. In order to model that market power s prevalent n several Spansh ndustres, the degree of competton s allowed to vary among ndustres, accordng to the degree of frm concentraton: Hgh concentraton (hgh Herfndahl ndexes) corresponds to less compettve sectors. The hgher concentraton, the hgher mark-ups. Ths prcng rule s based on the dea that frms face demand functons wth a negatve slope as well as Cournot competton,.e., frms take the supply of the others as gven when decdng ther own producton. The rule s obtaned from the frst-order condton for proft maxmzaton, gven ncreasng returns to scale due to the exstence of some fxed labour and captal costs. All frms wthn an ndustry are dentcal. There s free entry and ext of frms n each sector, so that n equlbrum, profts are zero and prce equals average costs, nclusve of the fxed costs. Defnng the mark-up as the prce-cost margn (P-MC)/P = MARKUP, and usng that, n equlbrum, prce s equal to average cost (P = AC), we fnd that MC/(1-MARKUP) = AC. Ths mark-up s specfed as follows: (1) MARKUP = Ω E κ d, =1,,16 7

10 Ths s the Lerner ndex for sector, and depends on three varables: The conjectural varatons parameter Ω (n our case: Ω = 1 3 ), the perceved elastcty of demand faced by sector (κ d ), and the share of a typcal frm n sector 's output, that s equal to the nverse of the number of frms n each sector (1/E ). Ths share can be proxed n the benchmark by the Herfndahl ndex (see Appendx 3), under the assumpton of symmetrc frms n each sector. The producton sector s specfed by 16 ndustres (see Table 1). Frms maxmse profts subject to a producton technology charactersed by a detaled, nested structure (see Fgure 1). CO 2 emssons from frms orgnate from the use of fossl energy as nput factors. In our statc framework, nvestments show ther nfluence on the economy as a component of fnal demand. Prvate households are assumed to share homothetc and dentcal preferences. Hence, they can be represented by a sngle, representatve household. The household maxmses a nested welfare functon (see Fgure 2) by choosng savngs 4, lesure, and consumpton of goods (ncludng energy). The household generates CO 2 emssons when t consumes coal, ol and gas. However, the qualty of the envronment s not specfed n the welfare functon. Endowments of captal, as well as sklled and unsklled labour, are fxed. The labour supply s elastc up to these fxed maxmum amounts. Ths feature of the model enables us to analyse to what extent adjustments of labour supply explan changes n the unemployment rates. Based on Balstrer (2002), we assume a case of equlbrum unemployment, nspred by a matchng specfcaton and the theory of external economes (see, e.g., Markusen, 1990). A matchng functon gves the number of jobs formed as a functon of the number of workers lookng for a job (unemployed), and the number of frms lookng for workers (vacances); see Petrongolo and Pssardes (2001) for a recent survey of the matchng functon n macroeconomcs. Wth ths approach, frctons due to lack of nformaton, mmoblty, search costs, heterogenetes across workers and jobs, etc. can explan the exstence of unemployment or vacances. Followng Balstrer, we model frctons by assumng that workers have to spend some resources n fndng a job, so the search process s costly. 3 Usually conjectural varaton s defned so that t s equal to zero wth Cournot competton. However, here the conjectural varaton parameter s normalzed to unty. 8

11 We assume that all search costs are borne by the workers. Ths means that real receved wages, net of taxes, W j, nclude a premum ( 1 H j > 1) on reservaton wages (Wj 0) that represents search costs: (2) W j j 1 = W 0 j, j = s,us, where s = sklled, us= unsklled workers. H Another feature of Balstrer s approach s externaltes. The unemployed vews the search cost as gven. However, the rsk of not beng matched, represented by the search cost, s affected by the behavour of all other agents. If, for nstance, the labour market expands, labour demand ncreases and the cost of partcpatng n the market falls; t s easer to fnd a job. If the unemployment rate ncreases, vacancy congeston decreases and the matchng process eases. We model ths by assumng that the H-functons (nverse premum) has propertes smlar to matchng functons: ( ) LD j (3) H j = 1 U j LD j η 0 U j U j η 1, j = s,us, where a bar denotes a benchmark value for the referred varable, LD s aggregate demand for labour and U s the unemployment rate. H s ncreasng n LD and U,.e., the search cost s decreasng n the same varables. Followng Balstrer (2002), vacances are, for smplcty, absent n ths model, and labour demand s used as a proxy. Ths means that total employment follows the labour demand curve. η 0 s the elastcty wth respect to vacances. It measures the postve externalty caused by frms on searchng workers, here represented by a lower search cost. η 1 s the elastcty wth respect to unemployment and measures the postve externalty from workers to frms. The model s solved through Rutherford's (1999) method, whch treats general equlbrum models as mxed complementarty problems followng Mathesen (1985), and t s mplemented wth GAMS/MPSGE. It has been calbrated usng the Spansh Socal Accountng Matrx for 1990, MCS- 90, developed n Urel et al. (1997) and Gómez-Plana (2001), as the reference equlbrum. Elastctes are taken from avalable emprcal evdence. See Appendx 3 for more nformaton on calbraton and data. 4 Gven our statc approach, we consder a untary elastcty of substtuton between consumpton and savngs (see Howe, 9

12 2.3. A stylsed, reduced-form mnature model As a tool for the analyss n the next secton, we use a reduced-form, less specfed representaton of the model. Large-scale models may often appear as black boxes when explanng results. The mnature model reflects the major mechansms n the large model and makes them more transparent. It suppresses many detals of the larger model, for nstance s the dual labour market aggregated to one matchng model, and the product markets are, as well, merged. In eqs. (4) to (7) the equlbrum of the stylsed model s expressed by only four equatons, the labour market equlbrum, the trade balance, the ndrect welfare functon and the captal market equlbrum. All other equatons and equlbrum condtons, such as the product market equlbrum and the publc budget constrant, are mplctly defned: 5 (4) L S (W, R, U; ε)(1-u)=l D* {W, R, ε, X[W, R, ε, Q cg (W, R, U; ε)]}= L D (W, R, U; ε) (5) D =D * {W, R, ε, Q cg (W, R, U; ε)}= D(W, R, U; ε) (6) WF = WF * {Q cg (W, R, U; ε), L S (W, R, U; ε)} =WF(W, R, U; ε) (7) K =K D* {W, R, ε, X[W, R, ε, Q cg (W, R, U; ε)]}= K D (W, R, U; ε) Notaton 6 : L S = L D = labour supply labour demand W= the labour rent/the wage rate R= the captal rent/the user cost of captal U= the unemployment rate ε= vector of all exogenous varables X= domestc output 1975). Savngs can be nterpreted as the purchase of bonds for future consumpton. 5 A detaled presentaton of the stylsed model and ts reducton nto four equatons s avalable from the authors on request. See also Fæhn and Grünfeld (1999) for a more extensve presentaton of a smlar procedure. 6 Note that a star after a symbol represents a dfferent functonal form, e.g. WF*(.) and WF(.) are two dfferent functonal forms expressng the varable WF. 10

13 Q cg = D = demand for aggregate consumpton of goods fxed trade balance WF = welfare K = K D = fxed total captal captal demand Eq. (4) represents the unemployment-adjusted labour market equlbrum, correspondng to eqs. (A6) and (A7) of the numercal model. 7 It dstngushes between fve effects of changes n the endogenous W, R and, U, and ε, whch ncludes exogenous reform components lke tax rates and emsson restrctons (determnng the quota prce; see eq. (A31)): () Substtuton effects: The frst appearance of W, R and ε n the L D* - functon represents changes n relatve labour to captal demand of alterng wages, captal rents and exogenous varables. () Compettveness effects: W, R and ε also affect labour demand through alterng producton costs and thus the nternatonal compettveness of Spansh frms. Ths alters output (X) and subsequent nput of labour. () Home market effects: Output s, as well, dependent on the domestc demand for the fnal good, Q cg, whch s a determned by prces and ncome. These are functons of factor prces, the unemployment rate that frst of all affects the ncome of the aggregate household, as well as exogenous varables. (v) Labour supply effects: Left hand sde of eq. (4) shows that through the household s decsons, labour supply s dependent on the same prce and ncome determnants as the demand for fnal goods descrbed above. (v) Unemployment wedge effect: The term (1-U) captures that the unemployment rate nfluences the labour market equlbrum drectly. 7 All equatons of the full model are lsted n Appendx 2. See also Appendx 1 for the notaton of the model. 11

14 The net current account s restrcted through fxng the trade balance to D, as n eq. (5). Ths corresponds to eq. (A.37) n Appendx 2. Eq. (5) dstngushes between two channels, through whch the endogenous and exogenous varables nfluence the current account: (v) Compettveness effects: The current account restrcton responds to cost changes that alter the compettveness of Spansh frms, and thus mports and exports. (v) Home market effects: Effects of changes n the domestc fnal consumpton, Q cg comes through mport leakages. Eq. (6) defnes welfare as a functon of the utlty of demanded consumpton goods, Q cg, ncludng savngs, and demanded lesure, whch s mplctly a functon of labour supply, L S (see eqs. (A17) and (A20)). The determnatons of Q cg and L S are explaned above. Equlbrum captal demand, K D, s restrcted to the gven captal stock, K. As eq. (A5) of the numercal model, eq. (7) ensures ths. Analogous to the labour demand, captal demand s nfluenced by Substtuton effects, Compettveness effects and Home market effects. The four equatons solve for the four endogenous varables WF, W, R and U. We can reduce the model further, by solvng eq. (6) for W, eq. (7) for R, and then nsertng the latter nto the former. For a gven ε, W and R are determned by WF and U: (6'): W=W(WF, U; ε) (7'): R=R * (W, U; ε)= R(WF, U; ε) Usng eqs. (6') and (7') leaves us wth the labour market equlbrum and the current account expressed n eqs. (4) and (5) as functons of only two endogenous varables, WF and U, whch agan mplctly determne all other varables n the model. The beneft of reducng the model n ths manner s that shft analyses of CO 2 polcy reforms and recyclng schemes on ths two-equaton verson wll drectly gve us the resultng welfare and employment dvdends,.e., the endogenous changes n WF and U. In Fgure 3, the two-equaton model s presented. The LL 0 -locus and the DD 0 -locus are defned as the combnatons of WF and U that for the exogenous benchmark values, ε 0, fulfl eqs. (4) and (5), 12

15 respectvely. Where both condtons are fulflled we fnd the equlbrum soluton of the model n the benchmark case,.e. n the ntersecton coordnate (WF 0, U 0 ). Both the slopes of the loc, as well as shft effects of exogenous reforms wll depend on the relatve strengths wthn the Spansh economy of the mechansms ) to v) descrbed above. The slopes express the necessary change n U for dfferent, exogenous shfts n WF, keepng, respectvely, the labour market equlbrum and the trade balance ntact. They are dentfed by means of smulatons of the numercal model 8. To start wth the LL locus, ts postve slope mples that a dstorton n the labour market equlbrum resultng from a gven relatve ncrease n WF wll have to be neutralsed by a smultaneous ncrease n U. The explanaton s that ncreased WF, n solaton, creates a labour supply surplus n the Spansh economy, whle an ncrease n U creates a defct, whch rebalances the labour market. In other words, movng rghtwards and/or downwards from a pont on the LL locus produces a labour supply surplus, whle ponts to the left and/or above the locus represent stuatons wth labour supply defcts. The effects of a partal ncrease of WF work through factor prce ncreases n eq. (4) (from now on represented by the nomnal wage rate, W). 9 The excess labour supply resultng from a partal WF ncrease s due to a relatvely stronger jont nfluence of the wage ncrease va the postve effects (), () and (v) than va the negatve (). Ths reflects characterstcs of the Spansh economy: Though Labour supply effects (v) contrbute postvely, the major explanatons are the labour demand reductons resultng form Substtuton effects () and Compettveness effects (). Though the Armngton elastctes are not very hgh - cf. Table A3 - the fact that nternatonally competng ndustres are relatvely labour ntensve (partcularly metal producton contrbutes to ths) cause sgnfcant Compettveness effects of ncreased WF, and thus wages. The Substtuton effects are less easy to track, but the substtuton elastctes lsted n Table A3 ndcate rather responsve labour-to- 8 For smplcty, n these smulatons the labour market has been merged nto one n the numercal model, n order to operate wth only one unemployment rate, wage rate etc. 9 Smulatons on the numercal model show that the strongest mpact of WF on factor prces comes through the ndrect utlty expressed by eq. (6): A rse n WF wll have to nvolve real ncome mprovements, and for gven U, factor prce ncreases must take place. The smulatons show that a partal rse n WF causes wages to ncrease relatvely more than captal rents, and nomnal wages more than the prces of consumpton goods so that the real wages ncrease. In the followng we suppress the effects on captal rents, as they only work to dampen the conclusons from a dscusson focusng on nomnal (and real) wages. 13

16 captal rates at the frm level. Counteractng () Home market effects,.e., ncreased consumpton, cannot be gnored. A real wage ncrease nduces both substtuton and ncome effects n favour of ncreased consumpton. The subsequent labour demand ncrease s, however, weak due to the fact that consumer goods are relatvely captal ntensve - and becomes even more so when prces of labour ntensve goods ncrease n relatvely terms. Frst of all consumpton of trade servces, other manufacturers and rentng contrbute to the hgh captal ntensty. The respondng rse n U n order to neutralse ths excess labour supply s due to a domnatng Unemployment wedge effect (v) that causes a drect reducton of excess supply through a drop n the term (1-U) n eq.(4). 10 As llustrated n Fgure 3, also the slope of the DD-locus s postve, mplyng that WF and U work n opposte drectons on the trade balance. Partally ncreasng WF rses nomnal and real wages and affects the trade balance adversely both through Compettveness effects (v) and Home market effects (v). An ncrease n U wll help re-satsfyng the trade balance restrcton. The domnant effect of ncreased U n the Spansh economy s to decrease mport leakage through negatve Home market effects (v). Consumer goods wth hgh (nput-output-adjusted) mport shares are frst of all metals and other manufacturers. The slope of the DD-locus mples that beng off and above the DD-locus represents stuatons wth smaller defcts than requred by the current account restrcton, whle at ponts below the curve, defcts are too large. 3. EMPLOYMENT AND WELFARE EFFECTS OF CARBON PERMITS 3.1 Case A: Lumpsum recyclng In order to wnd up the man mechansms producng the results n Case A, we explot the stylsed model presented n Secton 2.3. In Fgure 3, the equlbrum soluton of Case A s marked n the pont (WF A, U A ), whch represents the ntersecton between the loc LL A and DD A. The respectve shfts from the LL 0 and DD 0 -loc reflect that the ε-vector has changed due to the exogenous restrcton on CO 2 emssons. The drect effect s to mpose a prce wedge between the consumer and producer prce 10 Other mentoned effects of U work n the other drecton. However, another effect of U, whch s suppressed n the stylsed model exposton, also contrbutes to reduce excess supply somewhat: Increased U reduces the search cost component of the wage rate drectly (see eqs. (A38) and (A39)) due to the externaltes of the matchng process (see eqs. (A40) and (A41)). 14

17 of fossl fuels. Fgure 3 shows that, relatve to the benchmark, both loc shft upwards n the relevant area. As explaned n Secton 2.3, these ponts are charactersed by WFs and Us that, for gven ε= ε 0, would create a labour supply defct. In other words, the partal effect of movng from ε 0 to ε A s to create a labour supply surplus that has to be neutralsed. Ths surplus s the net result of effects through the four man channels for ε-mpacts already descrbed n Secton confer eq. (6). The surplus s created by Compettveness effects and Home market effects. The former are due to a labour demand fall as nternalsng costs of emttng deterorates the compettveness of domestc frms. The latter are consequences of lowered real wages when prces rse. Ths dscourages consumers' demand for goods and, thus, frms' demand for labour. Nether the nternatonally exposed goods, nor the consumer goods have very hgh drect fossl fuel ntenstes, but as prces of nputs, frst of all electrcty and transport servces, ncrease, the CO 2 permt prcng sgnfcantly rases the costs wthn exposed ndustres and fnal goods ndustres. Labour supply effects and Substtuton effects contrbute to weaken, but not offsettng, the labour supply surplus; the frst through reducng labour supply, the latter through ncreasng labour demand. Labour supply falls as real household ncome drops n the wake of hgher consumer prces; consumpton of fossl fuels, as well as goods produced by fossl fuels, becomes more expensve. Substtuton effects contrbute to ncrease labour demand, as the captal-ntensve ndustres tend to face the hghest CO 2 permt costs. Ths causes a substtuton of relatvely labour-ntensve producton for captal-ntensve. However, as share of total captal use, the fossl fuel ntensve ndustres are not very mportant, so ths effect s small. Smultaneously, the DD-locus shfts from DD 0 to DD A. As the new (WF,U)-ponts le above the DD 0 - locus, we know that ther adjustments, n solaton, cause a current account mprovement from the benchmark (see Secton 2.3). For ths to balance current account, the CO 2 -polcy reform must have caused a correspondng current account reducton. The explanaton s that the lumpsum reform affects the current account through two man channels (see the ε's n eq. (7)): Increased emsson prces mply a compettveness loss that deterorates the trade balance. Ths negatve Compettveness effect turns 15

18 out to domnate the postve Home market effect caused by reduced mport leakage when domestc ncome decreases. The new ntersecton pont reflects that ntroducng a CO 2 permt reform wll not notably affect aggregate U. Ths mrrors that the fossl fuel ntensve part of the Spansh economy s not very labour ntensve, and only small amounts of labour s released by ts contracton. In fact, total employment ncreases slghtly (see Table 2a), reflectng that the negatve shft n the labour demand caused by Compettveness effects and Home market effects of the CO 2 permt prces, s more than offset n the new equlbrum by relatve wage reductons that stmulate demand. However, as labour supply smultaneously rses, the unemployment rate remans unaltered. The dsaggregated results reveal that the rse n employment only beneft the unsklled, whle employment of sklled labour falls margnally. The ncreased demand for unsklled most promnently takes place wthn Agrculture, Trade and Other manufacturng (ncludng the unsklled ntensve manufacture of textles and wood products). The smultaneous welfare loss amounts to 0.59 percent. Ths pure abatement cost les n the lower range of those from other European studes (see IPCC, 2001, Bye et al., 2002, Bosquet, 2000). One explanaton s dfferences n the employment results: European studes usually fnd that employment drops. Ths tends to ntensfy the abatement costs due to sgnfcant tax nteracton effects wth exstng labour taxes. 3.2 Case B: Recyclng through reduced payroll tax rates on all labour Addng recyclng effects of reduced payroll taxes on all labour to the pure abatement effects n Case A corresponds to the more polcy-relevant Case B, whch s also llustrated n Fgure 3. The move from (WF A, U A ) to (WF B, U B ) llustrates that the solated recyclng effects of ths scheme are to strengthen the employment dvdend and to partly offset the welfare loss. In terms of the loc, the paytroll tax reductons change ε and cause the loc to shft to LL B and DD B, both lyng below the respectve locs of Case A. Thus, cet. par., the WF and U movements would cause a net supply surplus n the labour market along wth an ncreased defct n the current account. Accordngly, as we are n a new equlbrum, the recyclng scheme has caused the opposte: A labour supply defct and a current account mprovement. These are results of counteractng effects that can be tracked by usng eqs. (6) 16

19 and (7), as above. In the labour market, Labour supply effects of the change n ε contrbute to ncrease net supply, as reducng payroll tax rates lowers costs and market prces. However, ths effect s nferor to the other three, whch all ncrease labour demand and cause the supply defct: Substtuton effects through lowered labour prces, Compettveness effects through the subsequent compettveness mprovements, and Home market effects through hgher real ncome and demand. The current account mprovement caused by lower labour costs s explaned by the favourable Compettveness effects. Home market effects counteract somewhat through hgher mport leakage, but turns out to be nferor. Table 2b shows that the unemployment rate for sklled and unsklled labour falls by 0.33 and 0.20 percent, respectvely, due to the recyclng scheme. Ths s due to the jont postve mpact of the Substtuton effects, Compettveness effects and Home market effects on labour demand compared to the lumpsum case. The effects are relatvely small, as also found n the surveys of Mors (1995), Majocch (1996) and Bosquet (2000). The recyclng effects ncrease welfare by 0.37 percent. Important reasons are that the substantal labour tax wedge s reduced and that employment ncreases. Comparng Case B wth Case A shows that the welfare gan of the recyclng almost bsects the abatement cost of the CO 2 permt system. Such weak double (welfare) dvdends of labour tax recyclng are found n most of the European studes referred to above. 3.3 Case C: Recyclng through reduced VAT rates The case of recyclng revenue through VAT reductons s also llustrated n Fgure 3. As for Case B, both loc are shfted downwards compared to the lumpsum case, ndcatng that the recyclng effects are to generate a labour supply defct, as well as a current account mprovement. However, none of the shfts are as strong as n the case of pay roll recyclng. In the labour market, postve Labour supply effects are outperformed by Home market effects and Compettveness effects of lower prces that stmulate labour demand. Substtuton effects are not promnent n Case C, as opposed to Case B. The favourable Compettveness effects also explan the current account mprovement. 17

20 The equlbrum of Case C s marked n the pont (WF C, U C ). A very weak employment dvdend s obtaned from the VAT recyclng, as opposed to the payroll recyclng, ndcatng that unemployment should rather be combated through drect reductons n labour costs. The employment stmul caused by the Compettveness effects and Home market effects are counteracted, but not offset by factor prce ncreases, leavng employment slghtly hgher than n the lumpsum case, see Table 2b. As reported n Table 2b, the weak double welfare dvdend s slghtly stronger n ths case than n the payroll recyclng case (Case B), ndcatng that there are relatvely hgh ndrect commodty taxaton through VAT n Span. Indrect taxaton contrbutes to dstort the choce between lesure on the one hand and labour supply and consumpton on the other. The ncrease n consumpton relatve to lesure due to the VAT reductons thus also contrbutes to the welfare mprovements. Smlar results are found for other countres (see the above mentoned surveys), though typcally the effects on welfare are weaker than n case of payroll reductons. Two other sgnfcant effects are at work n ths case. Frst, the VAT reductons contrbute to reduce the dstortng tax wedge on energy goods. Second, the ntal VAT taxaton on domestc output tends to outperform the jont VAT and tarff wedge on mports, mplyng a dstorton of resource allocaton n dsfavour of home-mad products. Thus, the relatve prce reducton of domestc goods resultng from the VAT recyclng, results n a welfare-mprovng ncrease of Spansh market shares at home. 3.4 Case D: Recyclng through reduced payroll tax rates on unsklled labour Dstrbutonal reasons could call for a recyclng polcy desgned to stmulate unsklled labour, n partcular, due to the fact that the unemployment rates are twce as hgh for unsklled as for sklled labour. Ths could also be a case for reapng hgher employment dvdends than n the case of nondscrmnatory payroll recyclng. If the fossl fuel ntensve ndustres use unsklled labour relatvely more ntensvely than sklled labour, a relatve subsdy to employment of unsklled workers could help to absorb the released labour more effcently. Also, the relatve effect on wage costs of lowerng payroll taxes wll be hgher for unsklled labour than for sklled, due to the low wage rates of unsklled workers, mplyng that the change n the wage costs wll be larger. However, our results contradct the hypothess that employment dvdends ncrease when recyclng s targeted to the low sklled. We fnd 18

21 a much smaller employment dvdend n macro n ths recyclng regme than n the non-dscrmnatory recyclng scheme n Case B - see Table 2b. U falls by only 0.08 percent as opposed to a reducton of 0.24 percent n Case B, and the ncrease n aggregate employment s also lower. Behnd these aggregate results le sgnfcant dfferences between the two skll groups. Whle the nondscrmnatory recyclng n Case B ganed both groups, exclusvely recyclng through the costs of unsklled labour reduces the unemployment rate for ths group, only. Ths s offset by a rse n the unemployment rate of sklled labour. The recyclng effects are qualtatvely llustrated n the market dagrams for unsklled and sklled labour n Fgure 4a and 4b. In the unsklled market, the solated effect of reducng payroll taxes s to generate postve Labour supply effects through prce reductons, as well as postve Compettveness effects, Home market effects and Substtuton effects on demand. In partcular, the Substtuton effects contrbute to a sgnfcantly hgher demand for unsklled labour than n Case B. Other cost changes, prmarly through factor prce ncreases, modfy the shfts. The subsequent labour supply defct s neutralsed by an ncreased unsklled wage rate and a reduced unemployment rate, and n the new equlbrum, the recyclng scheme has contrbuted to ncrease unsklled labour wages by as much as 4.76 percent, whle the unemployment rate has fallen by 0.42 percent, reflectng a labour demand ncrease of 1.10 percent and a somewhat weaker labour supply ncrease of 1.00 percent. In the market for sklled labour, the shfts are weaker, n partcular the demand shft, due to the sgnfcant counteractng Substtuton effects away from sklled labour caused by the cost reductons of unsklled labour. Before any adjustments n the wage rate and the unemployment rate of the sklled, the labour market unbalance s less serous than n the market for unsklled labour. The equlbrum unemployment rate and wage rate for the sklled part of the labour force ncrease by 0.19 and 0.65 percent, respectvely. The ncreased unemployment rate mrrors that the Substtuton effects are strong and contrbutes to leave sklled labour employment 0.32 percent lower than n the lumpsum case. The targeted recyclng to unsklled labour generates a weak welfare dvdend of about the same magntude as does the recyclng through all payroll taxes n Case B. Ths reflects the strong sgnfcance of employment effects n generatng welfare: Aggregate employment rses to about the 19

22 same extent n the non-dscrmnatory and dscrmnatory recyclng schemes, and ths contrbutes to ncrease welfare both drectly, as employment s sub-optmally low ntally, and through decreasng the number of unemployed. Compared to Case B, the employment of unsklled more than doubles. But at the same tme the employment of sklled labour decreases sharply and leave aggregate employment somewhat lower than n Case B. The downward pressure on sklled labour demand s manly explaned by three mechansms: Frst a general substtuton of unsklled for sklled labour wll take place n each frm, encouragng employment of unsklled at the expense of sklled. In addton, the relatvely sklledntensve part of the economy (manly wthn the servce sector) wll reduce ts ablty to attract resources as ther relatve costs ncrease. Ths contrbutes to reduce sklled labour demand n macro. The thrd effect comes through the nterplay between captal and labour demand. The drect effect of subsdsng the unsklled labour costs s to reduce relatve prces between unsklled and captal much stronger than n Case B. In relatvely unsklled-ntensve and captal-ntensve ndustres, not only a substtuton between labour types, but also a substtuton for captal, takes place. Thus n the expandng part of the economy, most promnently wthn trade and unsklled ntensve manufacturng, captal demand decreases. The captal must be absorbed elsewhere, and through relatve factor prce adjustments, the contractng, sklled ntensve part of the economy s stmulated to absorb captal. Subsequently, captal demand ncreases n spte of output reductons n the hgh-sklled servce sector, mplyng that sklled labour s squeezed both by unsklled labour and by captal. As a result, aggregate producton and employment falls relatve to Case B, and ths tends to take place n the relatvely sklled-ntensve part of the economy, prmarly wthn the sklled servce sector. Our results counter the clams that targetng the revenue to the low sklled reduce employment more effectvely. Lke Bosello and Carraro (2001) we fnd that subsdsng costs of both types of labour s better than targetng revenue merely to the unsklled. Whle ther results are manly explaned by substtutablty between the two labour types wthn the producton processes, our fndngs for Span also pont to mportant effects from changes n the ndustral structure, and from the substtuton between captal and the two labour types both at the frm level and n macro through resource 20

23 reallocatons among ndustres. Ths leads naturally to the queston addressed n the next secton of whether targetng to sklled labour have more promsng employment effects. 3.5 Case E: Recyclng through reduced payroll tax rates on sklled labour Qualtatvely, the opposte story as for Case D apples to ths case of recyclng exclusvely through sklled labour costs, and t can be llustrated smply by changng the labels of the Fgures 4a and 4b. As n Case D, dscrmnatng between labour groups generates strong substtuton effects that explan most of the dfferences between the dscrmnatory and non-dscrmnatory cases, but here the opposte labour demand mpulses wth respect to skll groups occur. As reflected n Table 2b, wage rates for the sklled ncrease more than for the unsklled, and the unemployment rate falls for the sklled, whle that of the unsklled ncreases. The most nterestng observaton from the analyss of Case E s the strong employment dvdend obtaned n macro. The overall unemployment rate drops by 0.44 percent, whch mples that recyclng through sklled payroll tax rates turns out as the most recommendable scheme, and notceably more effectve than recyclng though the wage costs of unsklled labour (Case D). Behnd ths result le both a hgher labour demand and a lower labour supply than n Case D. The hgher labour demand s partly explaned by a stronger effect on demand for the subsdsed skll type n Case E than n Case D, because the tax cut s more substantal when allocated to the relatvely fewer sklled workers. In addton, hgher labour demand s due to a stronger negatve mpact on the dsfavoured skll type n Case D than n Case E. We have to revst the role of the nterlnkages between the demand for captal and the two labour types, n order to understand ths. In both cases of dscrmnaton, the subsdsed skll type ncreases ts ntensty wthn frms, and ndustres usng t relatvely ntensvely ncrease ther share of total producton. However, the two recyclng schemes dffer n ther effects on captal demand. Compared to the unsklled ntensve ndustres, the sklled ntensve ndustres are relatvely less captal ntensve and the substtuton between captal and labour smaller. Thus, reducng the payroll tax on sklled labour and thereby ncreasng relatve costs of captal n the sklled ntensve part of the economy, releases less captal, cet. par., than do a reducton of pay roll taxes of unsklled labour. Consequently, when the recyclng s targeted to the use of sklled labour, absorbng the released captal wthn the unsklled-ntensve, relatvely captal ntensve, 21

24 contractng part of the economy s a smoother process than n Case D. Less labour s substtuted by captal wthn these ndustres than wthn the contractng ndustres of Case D, subsequently the decrease of unsklled labour demand s smaller than that of sklled n the former case. When recyclng s targeted to sklled employment, frst of all servce ndustres where hgh sklls are requred, expand. However, compared to a targetng to unsklled, the contracton of the ndustres that use the relatvely dsfavoured skll type more ntensvely (n ths case the unsklled) s less pronounced. All n all, producton and employment ncrease compared to the two other, and more frequently analysed, cases of pay roll reductons. Along wth a hgher aggregate labour demand, the hgher employment dvdend n Case E than n Case D s explaned by a lower aggregate labour supply. Ths s related to a hgher labour supply elastcty of unsklled workers than of sklled. The wage rate of the non-subsdsed skll type - also n real terms - falls by about the same magntude n the two cases. However, the subsequent dscourage of the sklled labour n Case D s much smaller than that of the unsklled n Case E and contrbutes to a lower aggregate supply n the latter case. The fact that the wage rate of the sklled - also n real terms - ncreases consderably more n Case E, when sklled are favoured, than does the wage rate of the unsklled n Case D, modfes the dfference n supply between the two cases, but all n all supply turns out lower when the relatve subsdes are targeted to sklled employment rather than to unsklled. To sum up, the result of a 0.04 percent ponts hgher employment and 0.03 percent ponts lower supply n aggregate terms n Case E than n Case D explans the consderably lower U. It s, however, worth notcng the adverse effects the scheme n Case E has on the dstrbuton of the unemployment burden. In all the other cases, the recyclng schemes work to reduce the unemployment rate of the unsklled. Whle subsdsng unsklled labour produces the greatest dfference between the skll groups n terms of unemployment, t goes n favour of the relatvely low waged and low sklled. Subsdsng sklled produce the opposte result. The weak welfare dvdend of the recyclng scheme s of the same magntude as n the other pay roll reducng schemes. It s worth stressng that the welfare measure does not consder dstrbutonal concerns. 22