Environmental Tax Interactions when Pollution Affects Health or Productivity

Recent studies indicate that interactions with the tax-distorted labor market increase the cost of pollution regulation. However, these studies make restrictive assumptions regarding preferences and ignore key links between pollution, human health, and labor productivity. Together, these assumptions imply that pollution does not affect labor supply. This paper develops an analytical general-equilibrium model that considers several potential benefits from reduced pollution, including improved health or productivity. It shows that these benefits affect labor supply and thus create a benefit-side tax-interaction effect that can be of the same magnitude as the familiar cost-side interaction. When reduced pollution boosts labor productivity, the effect substantially magnifies such benefits. In contrast, when pollution affects consumer health, the effect tends to diminish the benefits of reduced pollution. The paper considers only environmental regulation, but these concepts apply equally to other policies affecting productivity or health, such as research subsidies or occupational safety regulations.