Pollution, Factor Taxation and Unemployment

It has been argued that by imposing taxes on pollution one can use the additional tax revenues to replace labour taxes in order to reap a double dividend in the sense of increasing the environmental quality and alleviating unemployment. This paper elaborates the employment effect of a revenue-neutral green tax reform which raises taxes on energy input and reduces the tax rate on labour input in a Nash bargaining model with two factors of production and a downward sloping demand in the goods market. It is shown that such a tax reform will boost employment if it leads the trade union to accept the same or lower nominal wage. This is the case when the elasticity of substitution between labour and energy is equal to or greater than one. If the elasticity of substitution is smaller than one, the trade union succeeds in increasing nominal wages thus making the effect on employment ambiguous. In this low substitution case there exists a critical level of the elasticity of substitution for an employment-neutral green tax reform and the likelihood of success in boosting employment decreases with the bargaining power of the trade unions.