Output welfare and equilibrium in EGEM

EGEM models the economy in aggregate with no sectoral breakdown of production and works solely in monetary units, as its equations are estimated from national accounts data. Therefore, there is no measure of household utility and the implied measure of global welfare is economic activity expressed as GDP/GNP. GDP is based on the standard national accounting identities, with all components except government expenditure and government investment being endogenously calculated in the model;

government investment and expenditure is calculated based on historic levels adjusted for transfers to the unemployed.

For each country in the model the long run level of domestic economic activity is driven by labour force growth, exogenous technical progress and expansion in world trade. Labour markets do not a priori clear, so persistent involuntary unemployment is possible, due either to high real wage costs (which can persist due to bargaining effects) or to insufficient demand, and this is indeed a feature of model forecasts. There are no resource constraints on the growth of the productive sector, though the price of traded commodities (including oil) rises slowly with increased global consumption.

Real output in each country is equal to the sum of consumption, investment, trade in goods and services and balancing financial asset flows to the rest of the world. Output grows over time because nominal compensation to employees grows with exogenous productivity growth. In response to the rise in income, investment also rises and the effects of these increases feed into the trade and financial sectors. Below we discuss the crucial equations governing the short to medium term behaviour of EGEM: that is, the wage, price, employment, trade and investment equations. All these equations are represented by error correction models based around cointegrating relationships, and so have unique long run solutions.

Wage/price responses to energy taxes

The form of the wage equation determines how much workers are able to offset the rise in consumption prices due to energy taxation with higher real wages; if wage increases outstrip productivity growth, unemployment and inflation is likely to increase in the medium term. Disregarding long run output effects, revenue recycling through direct taxation should leave real disposable income to consumers unchanged. However, the dynamics of price adjustment can lead to increases in perceived purchasing power, and inflationary or deflationary spirals in the short to medium term.

In EGEM, wage equations are based on a 'bargaining' type model in which real wages rise with labour productivity growth and fall with unemployment. Nominal wages depend on factory gate prices (Layard et al. 1991), and the inflation rate has a positive long run effect on nominal wages in some countries. In the long run wages do not rise to account for increases in consumer taxes; that is, the 'wedge' is equal to indirect consumer taxation, import and energy prices. In the short run however, import prices and indirect taxation can inflate wages. The nominal wage/price system is indeterminate and prices increase proportionately to changes in labour, energy and import costs. Prices also rise to reflect demand pressures in the economy, which are measured by capacity utilisation; this is defined as the ratio of industrial production to potential output calculated from the supply side equations described below.

The form of the wage equation is critical when tax recycling through employers' labour tax contributions is modelled. The imposition of a carbon tax effectively reduces workers' real wages if it is not recycled, because the rise in the aggregate price level is uncompensated. If the tax is recycled through employers' labour tax contributions then in a perfectly competitive market, and ignoring changes in factor usage, output prices would drop proportionately to the tax increase, leaving the aggregate price level and thus real wages unchanged in the long term. However, in an imperfectly competitive market some of the savings in labour taxes may be retained by firms as extra profits, or workers may expect this to happen. Therefore, prices (or expected prices) will be permanently higher than before the tax was imposed, and there will be pressure for wage increases from the workforce with consequent effects on inflation, monetary policy, competitiveness and employment. Such expectation effects can be modelled in EGEM by an adjustment to the wage equation that allows long run changes in the wedge to be lower than the change in indirect taxes. If lower producer wages from labour tax recycling give any reductions in unemployment this will also put upward pressure on wages because the expected cost of unemployment to workers has fallen, and so their bargaining position has strengthened.

The effects of tax recycling are different for the employed and the unemployed, and this has importance for the political economy of imposing energy taxes. Employees would prefer to see taxes recycled through direct taxation, as this would directly compensate them for higher prices. If the revenue is recycled through employers' labour tax contributions the effect on real consumption wages is ambiguous; if tax reductions are passed through in prices there will be no net change in real incomes, but if some is retained by firms as profit then existing workers will suffer an absolute pay cut. On the other hand any unemployed workers who find work due to lower producer wages are unambiguously better off, whatever the change in prices.

Compared to lowering employers' labour taxes, reducing direct taxes is unlikely to produce much new employment, as real consumer spending on non-energy goods will be unchanged and leisure/work trade-offs are assumed to be small in an imperfect labour market. Therefore, with labour tax recycling the largest welfare gains are likely to accrue to initially unemployed workers who gain work due to reductions in labour taxes; there will be some benefit in this for existing employees as transfer payments will drop with unemployment. If price reductions are fully passed through to consumers, reduced transfer payments will give direct economic benefits to existing employees and so labour tax recycling will be superior to direct tax recycling for both groups. Even if firms raise their profits, labour tax recycling should lead to greater overall economic growth compared to recycling through direct taxes, as the taxation system will be less distortionary. Therefore, from an economic perspective recycling through employers' labour taxation is most likely to be the superior policy, but will only be acceptable to existing employees if the price of non-energy intense goods is expected to fall significantly as a result of tax recycling.

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