Environmental policy, firm dynamics and wage inequality in developing countries

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Abstract

This paper examines the effects of pollution taxes on wage gap, social welfare and the environment of a developing economy. In the short run, we find that a rise in the pollution tax has an ambiguous effect on the skilled-unskilled wage gap. However, the higher pollution tax can cause urban firms to exit in the long run. Capital is released to the rural sector and benefits the production of rural workers. These predictions are empirically validated. The higher pollution tax can yield a double dividend by not only reducing pollution emissions, but also mitigating skilled-unskilled wage gap in the economy.

Introduction

Economic growth has been a priority in policy design and implementation in many developing economies. The growth target may, however, harm the country's environment via consumption- and production-generated pollution emissions. The remarkable economic growth experienced in developing countries driven largely by a rapid expansion in production and consumption consequently can result in the speedy deterioration of the environment. The serious pollution currently experienced in China is a vivid example. China's air quality has been deteriorating since 2000 and getting worse from year to year. In 2013, the urban air pollution became so severe that 71 out of 74 cities monitored by the Chinese's Ministry of Environmental Protection failed to meet the safe air quality standard recommended by the World Health Organization's (WHO) (Wong, 2014). The exposure to excessive amount of pollutants released by motor vehicles, such as nitrogen oxide and ozone, along with other primary pollutants produced by fossil fuels combustion and industry emissions, like sulfur dioxide, has caused a large number of premature deaths and substantial monetary losses worldwide. It is estimated that air pollution in China claimed between 350,000 and 500,000 lives prematurely each year (Moore, 2014).

To combat the air pollution caused in particular by consumption-generated emissions, Chinese government has implemented various measures and policies to curb pollution emissions. These measures include the traffic restrictions implemented by the local municipality of major cities in China, such as the odd-even car plate restrictions by Beijing municipality, to reduce the number of cars on the road (Luo, 2014). In addition, as a measure to reduce the severe air pollution problem in big cities, firms located near Beijing have been ordered to move their production facilities to a new location which is far from the city. A notable one is the reallocation of the Shijiazhuang Iron and Steel Co, a subsidiary of China's largest steelmaker, to about 70 km away from its old site by the end of 2017 to reduce severe air pollution in Beijing. This company has steelmaking capacity of 2.6 million tons a year and has been emitting sulfur dioxide, nitrogen oxide, dust and smoke for nearly 60 years. The authority expects this relocation will reduce the emissions of smoke and dust, which will help improve Beijing's air quality. Other nearby steel plants, such as Bohai Group in Tangshan and Jinan Steel Group and Taihang Steel Group in Handan, have also been ordered to move from city centres to costal or special industrial zones by 2017 (Yu & Wei, 2016).

Although the measures to curb consumption-generated emissions have been introduced and implemented, policies on industrial emissions through production have remained veiled in China and other Asian economies.1 Recently, a draft on pollution fees was released on the basis of the user's pay principle that companies and individuals who directly discharge pollution emissions would be subject to taxation and fine. Although this plan is expected to yield an estimated 22.8 billion to 45.7 billion yuan in annual tax revenue, the effects on emission reductions and related impacts to the economy have yet to be discussed and examined.

The economic impacts of environmental regulations are well studied in the literature. In particular, many prior studies explore the relationship between environmental regulations and foreign direct investment (FDI) in the attempt to find support for ‘pollution haven hypothesis’ (PHH). The PHH posits that to lower cost, investors from developed countries seek to locate their industries in countries with less stringent environmental regulations (Erdogan, 2014). Dean (1992) and Erdogan (2014) survey the empirical literature on the sensitivity of FDI to environmental regulation, and find little evidence to support for the PHH. A number of prior studies have also investigated the impact of environmental regulations on innovation, especially green innovation (e.g. Aghion, Dechezlepretre, Hemous, Martin, & Reenen, 2016; Dekker, Vollebergh, de Vries, & Withagen, 2012; Johnstone, Hascic, & Popp, 2010; Popp, 2002). These studies find that environmental regulations have a positive impact on innovation. In regard to the studies on income inequality and environmental quality, Torras and Boyce (1998) show that income inequality has mixed effects on environmental quality. When sulfur dioxide and smoke are used as the pollution variable, the authors find that pollution level is positively associated with income inequality in low-income countries. However, contrary results are obtained when heavy particles and dissolved oxygen are employed as the pollution variable (Torras & Boyce, 1998). Nonetheless, synthesizing the past evidence of a negative impacts of income inequality on environmental quality, Islam (2015) suggests that income inequality negatively affects environmental quality through four channels: household, community, national and international channels. Although there is a vast literature on the economic impacts of environmental regulations, little attention has been paid on the effects of environmental regulations on income inequality.

The purpose of this study is to fill in this gap. Our main contribution is to investigate the effects of environmental controls and regulations on the economy and environment from production-side consideration. Specifically, we pay attention to firm dynamics, where favorable development policies together with lax environmental policy can make the number of urban firms in the industry to be excessive in developing economies. This causes severe production-generated pollution emissions, which harm consumers in those economies. Urban firms can then either abate emissions or pay pollution taxes to pollute. In the short run with a fixed number of urban firms, we find that an increase in pollution taxes can narrow or widen the wage gap depending on the capital substituting and capital releasing effects on urban firms. However, in the long run, the higher pollution tax on producers could cause firms to exit from the urban manufacturing sector. Capital is then released to the rural sector and can in turn benefit the production of rural workers, when the firm-exit effect is sufficiently strong. The higher pollution tax can therefore yield a double dividend in the long run by not only reducing pollution emissions, but also mitigating wage inequality between skilled and unskilled labor for the developing economy. The theoretical predictions obtained are then empirically validated. Using a sample of low- and middle-income countries (including China), we provide empirical evidence to support the predictions derived in the theoretical model regarding both the short- and long-run effects of environmental regulations (or pollution tax) on income inequality. Our results show that income inequality can be mitigated when firm-exit effect is taken into account.

This paper is organized as follows. Section 2 sets up a general-equilibrium model for a dual developing economy, in which environmental taxes are imposed on urban manufacturing firms for pollution emissions. Section 3 examines the short- and long-run effects of an increase in pollution taxes on income distribution and social welfare of the economy. Section 4 presents the empirical methodology and discusses the regressions results. Section 5 concludes.

Section snippets

The model

We consider a developing economy with a dual structure of production: a manufacturing good X is produced by n firms in the urban sector and the agricultural commodity Y is produced in the rural sector. During the production process of the manufacturing good X, pollutants are however emitted as by-products. Urban manufacturing firms can either abate the pollution emissions or pay pollution taxes to emit. Choosing good Y as the numeraire, the relative price of the manufacturing good X is denoted

Pollution tax, wage inequality and social welfare

We begin with a study on the environmental regulation, say, a rise in the pollution tax, on factor returns and then to social welfare for the short and long runs. In the developing economy, capital tends to be located in the urban sector due to favorable development policies, including lax environmental regulations, to urban firms (Restuccia & Rogerson, 2013). This can result in less capital located in the rural sector, causing low wages for unskilled labor in the rural sector. The relationship

Empirical analysis

This section empirically examines both the short- and long-run theoretical predictions obtained in Propositions 1 and 3 in Section 3. The main predictions of our theoretical model are:

1) In the short run with fixed number of firms, an increase in pollution tax has an ambiguous effect on the skilled-unskilled wage gap in the economy. In other words, an increase in pollution tax can have a positive, negative and no effect on wage gap.

2) In the long run with free entry or exit of urban firms, an

Results

Table 2 reports the regressions of the proxy of environmental regulations on income inequality. Since prior studies suggest that income inequality affects environmental sustainability (Torras & Boyce, 1998), we estimate Equations (32), (36) using the system Generalized Method of Moments (GMM) estimator proposed by Arellano and Bover (1995) to address the endogeneity concern. Although the system GMM estimator are commonly used to estimate the dynamic panel models, it is also appropriate for the

Conclusions

Using a general-equilibrium framework for a dual developing economy, this study has investigated the short- and long-run effects of the rise in pollution taxes on income distribution, social welfare and environment. The developing economy is characterized by an imperfectly competitive urban manufacturing sector, together with a perfectly competitive rural sector. Specifically, we focus on firm dynamics, which due to the favorable development policies and lax environmental policy, could result

Acknowledgement

We appreciate the constructive suggestions and comments from Don Lien, Yiquan Gu, Da Huo, Hong Hwang, Wen-Jung Liang and Charles van Marrewijk. Xiangbo Liu acknowledges the research support by the Beijing Social Science Fund (Grant no. 14JGC119). This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

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