Green Policies and Public Finance in a Small Open Economy

Abstract

We explore the effects of greener preferences for the public finances, employment, and the domestic capital stock in a second-best framework. We find that greener preferences typically result in capital flight. Also, employment declines despite the factor substitution that is induced by a lower tax on labour and a higher tax on natural resources. If the uncompensated wage elasticity of labour supply is positive, private utility declines. Public consumption, in contrast, may rise if most of the improvement in environmental quality occurs through a lower level rather than a cleaner composition of economic activity. However, if the labour supply curve bends backwards, private utility rises while public consumption falls. I. Introduction The deterioration of the natural environment constitutes one of the major challenges facing public policy today. Business groups are concerned that environmental protection induces both capital flight and major losses in private income. Environmental groups, in contrast, maintain that a more ambitious environmental policy may not impose large costs. In particular, environmental taxation may be attractive, especially for the high-tax countries of Western and Northern Europe. In these countries, the