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ENVIRONMENTAL TAXES, INEFFICIENT SUBSIDIES AND
INCOME DISTRIBUTION IN CHILE: A CGE FRAMEWORK
Raúl O´Ryan*
Sebastian Miller y Carlos J. de Miguel**
Abstract
Successful economic growth followed by Chile, based on open market and export strategy,
is characterised by a high dependence on natural resources, and by polluting production and
consumption patterns. There is an increasing concern about the need to make potentially
significant trade-offs between economic growth and environmental improvements.
Additionally, policy-makers have been reluctant to impose standards that could have
regressive consequences, making the poor poorer. Using the ECOGEM-Chile model we
study the direct and indirect effects of imposing green taxes in Chile for PM10, SO2 and
NOx as well as taxes on gasoline. We analyse the effects over macroeconomic variables as
well as sectoral, distributive and environmental variables. We also analyse eliminating
distotionary subsidies that produce environmental and welfare losses. Evidence of welfare
gains, besides environmental gains, and trade-off among sectors is presented that can justify
tax/subsidies reforms in developing countries, replacing inefficient taxes/subsidies for more
efficient ones.
Keywords: Environmental Taxes, Double Dividend, Computable General Equilibrium
(CGE), Energy Subsidies.
JEL Classification: D58, H23, Q25
*
Centro for Applied Economics and Program for Environmental Economics and Management, Industrial
Engineering Department, Universidad de Chile.
**
Sustainable Development Area, Center for Public Policy Analysis, Universidad de Chile
1
I.- Introduction and history
The debate on the need to balance economic growth and environmental impact
appeared on the scene in 1972 when the Club of Rome issued its “Limits to Growth”
publication. Although this study had fundamental shortcomings because it did not take
economic forces into account, it did generate much awareness on ecological matters. Ever
since, the debate has continued with more and less controversial stands, but integrating
environmental and economic variables more appropriately (The Economist, 1997; Dasgupta
and Mäler, 1998; Kneese, 1998). In 1987, the Brundtland Commission defined the term
“sustainable development” as “development that meets the needs of the present without
compromising the ability of future generations to meet their own needs”. In practice, this
definition considers that any developing society must achieve its economic, environmental,
and social goals simultaneously (Pearce and Turner, 1990). Socio-economic goals consider
the need for economic growth, increased justice, and improved efficiency. Environmental
goals include system integrity, biodiversity, the ability to assimilate, and global concerns.
Finally, social objectives include participation, social mobility, cultural identity and
institutional development, among other concerns.
The Chilean Environmental Framework Law incorporates the concept of
Sustainable Development by supporting the idea that there can be no strong and stable
progress unless social justice and environmental care exist at the same time, which increase
the possibilities of fostering economic growth while protecting the environment,
eliminating poverty and attaining more social equity.
Chile’s successful growth of the past decade is well known, and so is the
comparative strength at the regional level that the country showed to cope with the Asian
crisis. Social policies have been significant, and have resulted in a remarkable improvement
in the Chilean people’s health care and education. Also noteworthy are the 38% and 60%
reduction in the number of extremely poor and poor, respectively, in less than ten years.
However, 23.2% of the population is still below the poverty line, and the unequal
distribution of income (wealth) remains with no visible change (MIDEPLAN 1997, 1998).
But this economic and social situation has left its print on the country’s natural and
environmental capital. Economic growth has been largely based on primary product
exports, directly related to the exploitation of natural resources. In 1995, agriculture,
forestry, fishing and mining accounted for a combined 15% of Chile’s current GDP, and for
47% of total exports. Another 26% is accounted for by primary-product-low-transformation
sectors such as the food, wood and paper industries.
On the other hand, comparing the relative growth and export evolution of the
aforesaid sectors in real terms, it appears that generally –and particularly the agricultural
and fruit sectors– have experienced relative reductions in their price evolution, which are
believed to be causing a negative effect on the country’s terms of trade.
In addition, economic growth has caused the creation of substantial pollution that
affect the country’s environmental quality. The development of manufacturing and mining
2
industries, not always with environmentally “friendly” technologies, together with the
concentration of the population in cities with no serious land planning to support the
migration, and the rapidly increasing number of privately owned vehicles, among other
factors, have taken their toll on the quality of water, air, and soil, and thus on the people’s
quality of life.1
With the creation of the National Environmental Commission CONAMA, the
Chilean Administration took a step forward in unifying the environmental policies, through
an agency that would identify the most critical aspects, create policies and monitor the
enforcement of regulations, standards and other measures applicable. There is a clear need
to create mechanisms that would permit evaluating the concept of sustainability in a
measurable way, systematically analyzing its three macro-objectives (i.e. economic growth,
social equity and environmental sustainability), also proposing alternative actions in
various scenarios for any of them. In general, however, studies are made within a partial
equilibrium context, which makes it difficult to analyze the implications of environmental
protection measures on equity and efficiency.
The complexity of direct and indirect relationships between economic,
environmental and social variables calls for models that allow evaluating priorities and
policies consistent with sustainability. Computable general equilibrium models are multiple
sector models that try to represent a country’s economy realistically, and have proven to be
useful instruments to describe these relationships together with providing an ex-ante
quantitative evaluation of the effects of different policies.
Initially, these models were applied to examine poverty and income distribution
problems, although later, trade issues took precedence among the applications. Today,
environmental issues (not forgetting social equity-related problems) have moved up the
priority scale, following the international diffusion of the concept of sustainable
development2.
The application of CGE models is important in a number of environmental aspects:
a) Models used to assess the effects of trade policies or international trade agreements on
the environment (Lucas et al 1992, Grossman and Krueger 1993, Beghin et al. 1996,
Madrid-Aris 1998, or various applications within the framework of the Global Trade
Analysis Program, GTAP).
b) Models used to assess Climate Change or Global Warming (Bergman 1991, Jorgenson
and Wilcoxen 1993, Li and Rose 1995, or Rose et al 1998), usually focusing on the
stabilization of CO2, NOx and SOx emissions.
1
The Index of Sustained Economic Welfare, albeit criticizable, (Neumayer, 1999), was run for Chile
(Castañeda 1997), and showed that over the past 30 years, despite the accumulated growth of 88% in
production, welfare has decreased by an estimated 4.9%, which shows the trend divergence since the
financial crisis of 1982.
2
Gunning and Keyzer (1993) perform a review of computable general equilibrium model applications to
developing countries.
3
c) Models focusing on energy problems (Piggot et al. 1992, Goulder 1993, Rose et al.
1995). These tend to use energy taxes or pricing to assess the potential impact of energy
price changes on pollution or cost control.
d) Natural resource allocation or management models (Robinson and Gelhar 1995,
Mukherjee 1996). Their objective is the efficient inter-regional or inter-sector allocation
of multiple-use natural resources, such as water resources in agriculture, mining,
manufacturing, tourism, human consumption, and ecological watercourses, to mention a
few.
e) Models focusing on evaluating the economic impact of specific environmental
regulations such as the US Clean Air Act or of environmental instruments (Jorgenson
and Wilcoxen 1990, Hazilla and Kopp 1990).
In this article, the Computable General Equilibrium Model ECOGEM-Chile will be
applied in order to analyze the direct and indirect effects of imposing new taxes on fuel,
PM10, SOx and NOx emissions on the level of emissions, production by sectors, and
income distribution.
After a brief introduction to the Chilean environmental reality, the theory on
environment-related taxes and the concept of double dividend, Section III will describe the
CGE model and the data used. Section IV presents different environmental tax scenarios
and possibilities of governmental compensation to remain in the initial real public savings
(expenditure) situation. The objective is to analyze tax reforms that may reduce the
emission of different pollutants, together with improving income distribution. The impact
of eliminating subsidies to coal production is also analyzed. Section V concludes.
II.- Environmental Status and Taxes
Only in the last decade, have concerns regarding the health and environmental costs
of Chile’s economic expansion been voiced strongly. Nevertheless, policies and programs
for sustainable development still play a secondary role in Chile. The historical lack of
environmental regulations and laws, or their ineffective application, has resulted in the
accumulation of many environmental problems, of which the most important are:
(a) Air pollution, linked to urban areas, industrial activities (pulp and paper, fishmeal),
mining and electricity generation. In specific areas, emissions of different pollutants
exceed the national normative or the international recommendations.
(b) High levels of water pollution caused by domestic and industrial effluents without
treatment. It affects surface water, ground water and coastal seawater.
(c) Water scarcity at regional level
(d) Inadequate urban development management, high levels of pollution, green or
recreational areas scarcity, etc.
(e) Inappropriate solid waste management and disposal, in particular hazardous wastes.
(f) Land erosion and degradation, associated to poor agricultural and forestry techniques,
urban growth and inadequate solid waste management. It mainly affects agricultural
land and river basins.
4
(g) Threats to native forest due to overexploitation (increase of forestry activity, coal
making, wood collection) and absence of effective protection.
(h) Hydro-biological resources overexploitation and biomass exhaustion
(i) Poor management of hazardous chemical substances.
The tradeoff between a better environment and growth, required to solve the
important social problems discussed in the previous sections, is very clear in the case of
Chile. Many of the most important economic sectors are related to natural resources
(mining, forestry, agriculture, and fishery), thus any action that reduces activity in these
sectors may have regional and/or countrywide impacts. Investments in pollution reduction,
in particular in Santiago, will require significant layouts, not necessarily paid exclusively
by those affected.
Air pollution in Santiago is the most obvious environmental problem of the country,
however other cities are also being affected. For Santiago, natural variables, demographic
growth, fix sources and mobile sources are principal causes. However, important reductions
in PM10 and PM2,5 (23,3 % and 46 % respectively) have been achieved since 1989. The
decontamination plan, elimination of 3.000 highly polluting buses, the incorporation of
natural gas in the productive process of fixed sources, and introduction of catalytic
converters in all new vehicles (as a result 50% of cars in Santiago 1999 have converters)
are main determinants of this improvement. Nevertheless, in 1999 there were 14
environmental pre-emergency events, the maximum of the 90s, and one emergency event
was declared3.
Table Nº1 Santiago Environmental Situations in the 90´s
Year Pre-emergency Emergency Year Pre-emergency Emergency
1990 11 2 1995 2 0
1991 9 2 1996 6 0
1992 14 2 1997 13 0
1993 8 0 1998 12 1
1994 3 0 1999 14 1
Source: SESMA (1999)
Index CO SO2 NO2 O3 Particulate
µg/m3 µg/m3 µg/m3 µg/m3
ppm
301-400 30 1.493 2.110 780 240
501 - > 50 2.620 3.750 1.400 330
3
An Emergency Program is being applied since 1990. It establishes several levels of air quality. When
pollution overcomes the 300-air quality index pre-emergency is declared, and emergency for 500 index.
The level is associated to:
5
 Transport is the largest sector in terms of air pollution. Mobile sources account for
92.3% of carbon monoxide, 70.6% of nitrogen oxides, and 45.7% of Volatile Organic
Compounds derived from fuel use. Private transport is generally more polluting in terms of
concentration of pollutants per vehicle mile traveled than public transport, except for PM10
emissions (see Table, p9, CONAMA, Libro Resumen del Medio Ambiente)
The following table shows Santiago’s air quality compared to other major cities that
are highly contaminated. It can be concluded that air quality is a major problem in the city.
Table Nº2 City Comparison of Air Pollution
City Total suspended Sulfur dioxide Nitrogen dioxide
(population in 1000’s) particles
Calcutta (11,923) 375 49 34
Beijing (11,299) 377 90 122
Mexico City (16,562) 279 74 130
Tehran (6,836) 248 209 ..
Bombay (15,138) 240 33 39
Bangkok (6,547) 223 11 23
Santiago (4,891)4 210 29 81
Manila (9,286) 200 33 ..
Athens (3,093) 178 34 64
Sao Paolo (16,533) 86 43 83
Lisbon (1,863) 61 8 52
Ankara (2,826) 57 55 46
Tokyo (26,959) 49 18 68
WHO Recommendations 60-90 40-60 ..
Because of differences in location and measurement, city comparisons are only indicative.
Commercial city center, µg/m3 annual averages, 1995
Source: World Bank databases (SIMA)
Table Nº3 Air Pollution in Santiago (1995)
Pollutant COb Ozonec PM10a PM2,5 a SO2 a NO2 a TSP a
Max. 35.6 224 302 174 161 254 621
Min. 0.1 1 8 4 7 4 31
Average5 2.04 13 87 42 17.8 64.8 186.3
a
data in µg/m3,b in ppm, c in ppb.
Source: SESMA, INE
Other problem areas in Chile include poor air quality in Concepción-Talcahuano
from steel, petroleum, fishmeal, paper and pulp industries and high levels of ground level
4
Average is not relevant in Santiago concerning the wide range of variation among the highest and lowest
concentrations.
5
The annual average is calculated as the annual average per month of all monitoring stations.
6
Ozone in Valparaiso-Viña del Mar. In this sense, Talcahuano environmental recovery plan
is operating and air monitoring systems are been establishing in several cities with the goal
of identify saturated zones. The following table summarizes air quality problems by region.
Table Nº4 Air Quality Problems by Region
Pollutant Source Affected Area
PM10 Copper Smelting II, III, V, VI Regions
Petroleum Refinery V Region
Cement Production V Region
Diesel Motors SMA
SO2 Copper Smelting II, III, VI Regions
Petroleum Refinery V Region
Cement Production V Region
Ozone Copper Smelting V Region
Petroleum Refinery V Region
Cement Production V Region
Vehicles SMA
Sulfhydric Acid Pulp and Paper VII, VIII and IX Regions
Fishmeal Industry VIII Region
Trimethylamine Fishmeal Industry VIII Region
CO and CO2 Vehicles SMA
NOx Vehicles SMA
Source: CONAMA-Univ de Talca-Univ. de Concepción
The biggest threat to health from air pollution comes from fine particles. Studies
indicate that there are significant effects on human health. For this reason, several
territories have been declared "saturated areas" for specific pollutants:
7
 Table Nº5 Saturated Areas in Chile
Region Territory Saturated of: Year
II Maria Elena, Pedro de Valdivia Areas PM 10 1993
II Chuquicamata Camp SO2, PM 10 1991
II Potrerillos Smelter Area SO2, PM 10 1997
III Hernán Videla Smelter Area SO2 1993
V Chagres Village Latent SO2 1991
V Ventanas Smelter Area S02, PM10 1993
VI Caletones Area S02, PM10 1994
RM Santiago Metropolitan Area PM10, CO2, O3, latent 1996
Nox
Source: CONAMA
Finally, other problems related to air are acoustic pollution in the city of Santiago
and bad smells surrounding fish meal and pulp and paper industries as well as dumping
grounds.
Despite these efforts, it is still necessary to continue reducing emissions, at an
increasing private cost. Therefore, alternative scenarios must be analyzed in order to
achieve larger reductions of –in this case– PM10, SO2 and NO2.
The meta-objective should be to attain optimal pollution levels, that is, to set a
socially optimal level of activity where the marginal net private benefit equals the marginal
cost generated by externalities. Because of the many theoretical and practical difficulties of
determining such a level of activity and create the proper measures to attain it, normally the
attempt is made to reach “acceptable” pollution levels. Some times the authorities substitute
more easily applicable emission limits for Pigouvian6 taxes or pollution fees, both because
public institutions are more used to them and because they are more politically acceptable.
In reaction to this regulatory practice that favors command and control instruments,
a vast literature that seeks to promote the use of economic instruments has developed.
These are more efficient, particularly because they allow achieving goals cost-effectively
and, at the same time, encourage technological innovation. Reviews on direct economic
regulatory instruments for pollution control and their applications on the international scene
can be found in Pearce and Turner (1990), Repetto et al (1992), OECD (1994), Sterner
(1994b), O´Ryan and Ulloa (1996), among others.
Among the most frequently applied “green” tax options for air pollution control, the
following stand out:
i) Taxes on emissions or effluents (a charge on the quantity and/or quality of air
pollutants) are applied in China, Poland, France, Sweden, etc.
6
The Optimal Pigouvian Tax is the equivalent of the damage caused by one marginal pollution unit in the
pollution optimum.
8
ii) Charges to activities causing an environmental damage (charges to the user of
contaminating processes or administrative charges on operations) are applied in
Singapore, Denmark, Sweden, etc.
iii) Charges to products (differentiated taxes that put a heavier burden on polluting
products) are used in the Netherlands, Sweden, Norway, etc.
There are experiences on the application of these instruments, especially in Europe,
but also in development countries, such as China. In practice, taxes have been used more to
collect money than to encourage a reduction in pollution.
Recently, the international literature has focused on analyzing the “double dividend”
concept”7. This concept highlights the potential gains from replacing the existing tax
structure that taxes “goods” by one whereby externalities are taxed. Thus, by introducing
an environmental tax that will replace other distorting tax (in terms of economic efficiency,
income distribution, etc.), and keeping fiscal collection constant, the quality of the
environment would be improved in addition to reducing economic distortions and
improving welfare. This concept has been thoroughly examined in developed countries,
where studies have been extended into the search for joint improvements in employment,
output, income distribution, environmental quality, and other indicators. However, the
results of the studies are inconclusive as to whether or not double dividend exists.
In any case, introducing environmental taxes may be beneficial even because of
only the first dividend, that is, improving the environment’s quality and correcting the
associated externality. Therefore, studies on the use of economic instruments for
environmental management (and eventually the existence of double dividend) maintains its
interest and can undoubtedly shed some light on future policies and their expected effects.
In the case of new taxes substituting for existing ones in the pursuit of joint
economic, environmental and/or social improvements, Fullerton and Metcalf (1997)
conclude that each type of reform must be evaluated separately. Therefore, one can not
believe in advance in the existence of double dividend per se. Moreover, because every
country has different tax structures and labor markets, to extrapolate a successful reform
from one country to another will not necessarily have the same results. Parry and Oates
(1998) consider that the results of the studies must not rule out the use of economic
instruments, but rather encourage new studies since there can be no certainty on the results
of any future environmental tax reform. In addition, they warn about the inability of partial
equilibrium studies to consider indirect effects of tax reforms on the different sectors..
This work will look for evidence of double dividend in the sense of concurrent
improvements in income distribution and air quality. The first objective of the applied
environmental taxes will be to reduce air pollutant emissions. From this necessary
condition, a tax structure change will be looked for that will permit to improve equity while
keeping real public saving constant. In this case, the double dividend will be “ethical” since
there is no reason why the replaced taxes in the fiscal reform will be less disturbing from an
7
In-depth discussions on the issue of “double dividend” can be found in Repetto et al (1992), Goulder
(1994), Fullerton and Metcalf (1997), Bosello et al (1998), Bento (1998), Jaeger (1999).
9
economic efficiency standpoint. In any case, the evolution of economic activity with
respect to the initial situation –before the policy– will also be controlled.
III.- The General Equilibrium Model: ECOGEM-Chile
III.1.- Characteristics of the model
The CGE developed for Chile is a static model characterized by sector multiplicity,
occupational category differentiation, income quintiles, trade partners, and specified
productive factors, among other features.8 It is basically a neoclassic model, which is
savings-driven. It incorporates energy-input substitution to reduce emissions because the
emissions are related to the use of different inputs and not only to production levels as is
generally dealt with.
Although not all the model’s equations are shown herein, the most significant will
be included, particularly those associated to environmental variables. The main indexes that
will be used in the model’s equations are listed below:
i, j Productive sectors or activities
l Types of work or occupational categories
h Household income groups (quintiles)
g Public spending categories
f Final demand spending categories
r Trade partners
p Different types of pollutants
Production: production is modeled by the CES/CET nested functions (i.e. constant
elasticity of substitution – transformation). If constant returns to scale are assumed, each
sector produces while minimizing costs:
min PKELi KELi + PABNDi ABNDi
s.t.
[
XPi = akel ,i KELiρ i + aabnd , i ABNDiρ i
p p
]
1 ρ ip
In the tree’s first level, decisions are made through a CES function to choose from a
non-energy-producing intermediate input basket and a factor basket (i.e. capital and labor)
and energy producing inputs (KEL). In order to obtain the non-energy-producing
intermediate input basket a Leontieff-type function is assumed. On the factors` side, the
capital-energy basket and labor is split through a new CES function, and then energy is
8
The model presented herein, ECOGEM-Chile, has been developed by PDS/CAPP and CEA/DII of the
University of Chile, based on the one generated at the OECD by Beghin, Dessus, Roland-Holst and van
der Mensbrugghe (1996).
10
separated from capital, always assuming CES functions for substitution both between and
within factors (types of labor, energy, and capital)9.
Income distribution: Production-generated income is allocated in the form of wages,
capital returns and taxes between the domestic economy, the Government, and the domestic
and international financial institutions.
Consumption: households distribute their income between saving and consumption
through an ELES utility function (Extended Linear Expenditure System)10. This function
also incorporates the minimum subsistence consumption as independent from the level of
income.
n
 S 
max U = ∑ µ i ln(C i − θ i ) + µ s ln
 cpi 

i =1  
n
subject to ∑ PC C
i =1
i i + S = YD
n
and ∑µ
i =1
i + µs = 1
Where U stands for the consumer’s utility; Ci is the consumption of good i; θ is the
subsistence consumption; S, saving; cpi, the price of savings; and µ the consumption
marginal propensity for each good and to save.
Other Final demands: Once the intermediate demands and household demands are
defined, there is only to include the rest of the final demands, i.e. investment, government
spending and trade margins. Other final demands of each item are defined as a fixed share
of total final demand.
Public Finances: regarding public finances, there are different types of taxes and
transfers. The following are defined in the model: labor tax (differentiated by occupational
category), taxes on firms, on income (differentiated by quintile), all of them direct. Also
import tariffs and subsidies are defined, together with export taxes and subsidies, (by
sector) and a value added tax VAT (for domestic and imported goods, and by sector).
As a closure condition for public finances, the model allows two alternatives: first,
government spending is defined as fixed and equal to the original level previous to any
simulation, allowing it to adjust through some tax or government transfer. Second,
government spending is allowed to vary, while taxes and transfers are kept fixed. The first
option was chosen herein.
9
See Annex #1, to see the way the nest is built.
10
The way in which savings are included (divided by a price index of the other goods) partially neutralizes
the substitution between consumption and savings, because the savings` price is a weighted price of all the
other goods. In this sense, savings represent future consumption.
11
 Foreign sector: to incorporate the foreign sector, the Armington assumption is used
to break down goods by place of origin, allowing imperfect substitution between domestic
and imported goods and services. As with production, there is a CES function that allows
substitution between the imported and the domestic basket. In turn, the domestic supply
gets a similar treatment as demand, now including a CET function to distinguish between
domestic market from exports.
For imports:
min PDXD + PMXM
[
subject to XA = a d XD ρ + a m XM ρ ]
1ρ
where PD and PM are the prices of domestic and imported goods, while XD and XM are the
respective amounts. XA stands for the good made up of both or the “Armington good”.
Parameter ρ is the substitution elasticity between both goods.
For exports:
max PD XD + PE ES
[
subject to XP = γ d XD + γ e ES λ ]
1λ
where PE is the price of the exported good and ES is the respective amount. XP is the
sector’s total production. Parameter λ is the substitution elasticity between both goods.
Factor Market Equilibrium Conditions: to achieve labor market equilibrium, labor
supply and demand are made equal for each occupational category, where supply is
determined on the basis of real wages. As for the capital market, a single type of capital is
assumed to exist, which may or may not have sector mobility depending in the imposed
elasticity; for this case no capital mobility between sectors is assumed.
It is worth noting that long-term elasticities have been assumed for the substitution
between the factor nest and non-energy-producing inputs, as well as for the CES between
capital-energy and labor, between capital and energy, and for the various energy-producing
sectors. Although this assumption allows for greater substitution between factors is more
realistic from a medium term viewpoint.
Closure Conditions: the closure condition for the public sector has already been
anticipated. Also, as is usual in these models, the value of the demand for private
investment must equal the economy’s net aggregate saving (from firms, households,
government and net flows from abroad). The last closing rule refers to balance of payment
equilibrium. This equation will be introduced into the model through the Walras Law.
12
III.2.- Emission Reduction Within the Model
The model allows three possibilities to reduce emissions of pollutants in the
economy. They all come from introducing some kind of tax or policy that alters the
economic players’ decisions in their profit or benefit maximizing processes. The first, most
traditional and common one in general equilibrium models, is the reduction in the
production of the very pollutant sectors. Number two is associated to the use of energy-
producing inputs that discharge emissions into the environment whenever they are used in
the productive process or in consumption, and allows to substitute less contaminating
elements for the more so. Number three is determined by the ability to reduce emissions by
the way of “end of pipe” technologies (e.g. filters, treatment plants, and the like). This
latter possibility is in its experimental stage and will not be included in the results of our
simulations.
Not included in the model is the possibility of technological change –from
investment processes based on relative returns– towards new supposedly less polluting
technologies, because it would be necessary to use a dynamic model. Although it is actually
possible to change substitution elasticities to simulate more flexible technologies to less
polluting processes. Also left out of the players’ utility function is the environmental
quality as a good for which there is a willingness to pay, and therefore alters consumption
decisions on the rest of the goods and their equilibrium prices.
Production Reduction: In this case, introducing a tax on emissions generates an
increase in production costs which in turn causes -ceteris paribus- an increase in the price
of the good produced by the polluting industry (that pays for the tax). Thus it becomes less
competitive at both the national and international level and reduces the amount demanded
for the good and also production, at least in the long run. In case of an environmental
regulation that sets a limit for emissions, the company will be forced to reduce its level of
production.
Basically, this possibility comes from making prices endogenous in the general
equilibrium model and the possibility of reallocating factors and resources among the
various productive sectors, substitution between different goods for final demand or
substitution between the domestic and the foreign markets (CES/ELES/CET-Armington
functions, respectively).
Substitution between inputs: the use of each type of input in either the production or
the consumption by final demand causes a certain level of emissions independently of the
productive process. Therefore, another way to reduce emissions is to substitute less
polluting inputs for the more polluting ones. In case of a tax on emissions, the costs
associated to the use of that input are being indirectly increased, and thus their relative use
is being made costlier and its substitution encouraged.
In case a new emission regulation is set, a constraint is introduced to optimization
both in the domestic economies and in firms. In this case, to continue using the same
volume of polluting inputs leads to a below-optimal situation that converges towards the
13
original optimum to the extent that substitution occurs towards less or non-contaminating
inputs.
The model basically differentiates between energy-producing and non energy-
producing inputs. Non energy-producing ones are used in the production function with
fixed coefficients. Substitution between energy-producing inputs