Neutralizing the Adverse Industry Impacts of CO2 Abatement Policies

47 Pages·2001·0.24 MB·English

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: Behavioral and Distributional Effects of Environmental Policy
Volume Author/Editor: Carlo Carraro and Gilbert E. Metcalf, editors
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-09481-2
Volume URL: http://www.nber.org/books/carr01-1
Conference Date: June 11–12, 1999
Publication Date: January 2001
Chapter Title: Neutralizing the Adverse Industry Impacts of CO2 Abatement
Policies: What Does It Cost?
Chapter Author: A. Lans Bovenberg, Lawrence H. Goulder
Chapter URL: http://www.nber.org/chapters/c10605
Chapter pages in book: (p. 45 - 90)
(cid:2)
2
Neutralizing the Adverse
Industry Impacts of CO
2
Abatement Policies
What Does It Cost?
A.LansBovenbergandLawrenceH.Goulder
2.1 Introduction
MoststudiesofU.S.CO abatementpolicieshavefocusedontheaggre-
2
gatecostsandbenefitsoftheseinitiatives.Yetthedesirabilityandpolitical
feasibility of these policies tend to hinge critically on their distributional
impacts. A full assessment of CO abatement options therefore requires
2
attentiontodistributionalimpacts.
Some studies—including Poterba (1991), Bull, Hassett, and Metcalf
(1994),Schilloetal.(1996),andMetcalf(1998)—havefocusedonthedis-
tribution of impacts of CO abatement policies across household income
2
groups.Inthesepapers,theinstrumentforCO abatementisusuallyacar-
2
bon tax. This tax is generally found to produce a regressive impact, al-
though this impact is fairly small, especially when one ranks households
by measures of lifetime income (such as expenditure) rather than by an-
nualincome(whichincludestransitoryshocksandlifetimevariationsthat
makeannualincomeabadindicatorofpermanentincome).Moreover,as
indicatedbySchilloetal.(1996)andMetcalf(1998),thegovernmentcan
reduce the regressive effect by lowering personal income tax rates at the
bottomendoftheincomescaleandbyraisingpublictransfers.
Asecondimportantdistributionaldimensionisthevariationinimpacts
A.LansBovenbergisprofessorofeconomicsattheCentERforEconomicResearch,Til-
burgUniversity,andaresearchfellowoftheCentreforEconomicPolicyResearch,London.
LawrenceH.GoulderisassociateprofessorofeconomicsatStanfordUniversity,aresearch
associateoftheNationalBureauofEconomicResearch,andauniversityfellowofResources
fortheFuture.
The authors are grateful to Gilbert Metcalf, Ruud de Mooij, Peter Orszag, Ian Parry,
JackPezzey,RobertStavins,RobertonWilliamsIII,andconferenceparticipantsforhelpful
comments,andtoDerekGurneyandRudolfSchusteritschforexcellentresearchassistance.
45
46 A.LansBovenbergandLawrenceH.Goulder
acrossindustries.CO abatementpolicies suchascarbontaxesorcarbon
2
quotas can reduce net output prices in the fossil fuel (carbon supplying)
industriesand raisecosts inindustries thatintensively employfossil fuels
as inputs. These price and cost impacts have the potential to seriously
harmprofits,employment,andequityvalues.Thedistributionofimpacts
along these dimensions crucially influences political feasibility, since rep-
resentativesoffossilfuelproducerscarrysignificantweightinthepolitical
process.1CO abatementpoliciesthatposeseriousburdensontheseindus-
2
triesmaystandlittlechanceofpoliticalsurvival.2
This paper explores the distributional impacts of various U.S. CO
2
abatement policies in terms of their impacts on profits and equity values
fortheindustriessupplyingfossilfuels(thecoalindustryandcrudepetro-
leumandnaturalgasindustry)andtheindustriesthatrelyheavilyonfossil
fuelsasintermediateinputs(e.g.,petroleumrefiningandelectricutilities).
Weexaminearangeofabatementpolicies,includingpoliciesdesignedto
avoidadverseconsequencesfortheregulatedindustries.Asdiscussedlater,
some of the adverse consequences can be avoided through industry-spe-
cific corporate tax cuts, direct transfers, and the government’s free provi-
sion(or“grandfathering”)3ofemissionspermitstofirms.Amainpurpose
of our paper is to assess the efficiency cost of avoiding adverse impacts
throughsuchpolicies.
Toperformthisinvestigationweemployanintertemporalgeneralequi-
librium model of the United States.4 The general equilibrium framework
1.Indeed,theindustry-distributionimpactsmaybemoreimportantpoliticallythanthe
household-distributionimpacts,sincethestakesforeachfirmfromthesepoliciesarehigh,
whiletheimpactsofabatementpoliciesonhouseholds,althoughimportantintheaggregate,
arefairlysmallforeachindividualhousehold.Underthesecircumstances,affectedfirmsmay
bemorewillingtoincurthecostsofpoliticalmobilizationthanaffectedhouseholdsare.This
discussion invokes the notion of political mobilization bias, an idea originated by Olson
(1965).Foradiscussionofthisbiasandotherpoliticaltransactionscostissues,seeWilliam-
son(1996).Forananalysisoftheimplicationsofpoliticalmobilizationbiasforlegislators’
choiceofenvironmentalpolicyinstruments,seeKeohane,Revesz,andStavins(1998).Fora
generaldiscussionofpoliticalresistancetomarket-basedenvironmentalpolicyinstruments,
seePezzey(1988).
2.Thiswillbethecaseirrespectiveoftheefficiencypropertiesofabatementpolicies.In
therealworld,winnersoftencannotcompensatelosersthroughcostless,lump-sumtransfers.
Hencethemostefficientpolicies—thosewiththelargestnetbenefitsintheaggregate—may
notyieldactualParetoimprovements:TheymayonlybepotentiallyPareto-improving.In
suchaworld,politicalfeasibilitymayrequiredesigningpoliciesthatavoidseriousnegative
impactsonkeystakeholders.Thismayinvolveasacrificeofsomeoftheefficiencygainsfrom
themostefficientpolicy.
3.Grandfatheringisaspecialcaseoffreeprovision.Itisalegalrulewhereby“old”entities
(e.g.,firmssubjecttopreviousenvironmentalrules)areexemptfromnewregulatoryrequire-
mentsandremainboundonlytotheearlier(andperhapsmorelax)regulatoryprovisions.
Undergrandfathering,thefreeprovisionofpermitsislinkedtocurrentproductionfactors.
Newlyenteringfirmsarenoteligibleforafreeprovision,andinvestmentsinnewcapitalare
notrewarded.
4.ThisisthesamemodelasthatinGoulder(1995a)andBovenbergandGoulder(1996,
1997),withsomeextensionstoallowforattentiontotheindustry-specificrevenue-recycling
andtradable-permitsprovisionsdescribedbelow.
NeutralizingAdverseIndustryImpactsofCO AbatementPolicies 47
2
is especially useful for assessing the incidence of carbon policies. Nearly
all of the studies of distributional impacts of carbon policies have em-
ployedapartialequilibriumframeworkthatignoresbehavioralresponses
to environmental taxes.5 These studies impose exogenous incidence as-
sumptionsandcannotanalyzehowbehavioralresponsesaffectpollution,
efficiency, and distribution. An applied general equilibrium analysis, in
contrast, derives tax incidence endogenously from the model-generated
behavioralresponses.Animportantdistributionalconsiderationistheim-
pactofCO abatementpoliciesonreturnstolaborandcapital.Ageneral
2
equilibrium framework is appropriate for this purpose, since it captures
important links between energy markets and factor markets. The model
used here is especially useful in this regard because it incorporates
forward-lookinginvestmentbehaviorandtheadjustmentcostsassociated
withtheinstallationorremovalofphysicalcapital.Thesefeaturesenable
us to consider the capitalization effects of unanticipated policies.6 Most
other general equilibrium models treat capital as perfectly mobile, and
thustheycannotsuccessfullyexamineimpactsonprofitsorequityvalues.
Insuchmodels,theimpactsonindustriesaremeasuredlargelyintermsof
theeffectsonoutputs.Theresultsfromthispapershowthatoutputeffects
areunreliableindicatorsofdistributionaleffects.
EarlieranalysesofCO abatementpoliciesrevealatensionbetweenpro-
2
motingeconomicefficiency,ontheonehand,andavoidingseriousadverse
distributionalconsequencestokeyindustries,ontheother.Goulder,Parry,
and Burtraw (1997), Farrow (1999), Fullerton and Metcalf (1998), and
Parry,Williams,andGoulder(1999)showthatpoliciesthatraiserevenues
and use these revenues to finance cuts in preexisting distortionary taxes
havelowercoststhanpoliciesthatdonotgenerateandrecyclerevenuesin
this way. The differences in the costs of the two types of policies can be
largeenoughtodeterminewhethertheoverallefficiencyimpact—environ-
ment-relatedbenefitsminuseconomy-widecostsofabatement—ispositive
ornegative.7Yetthelatter,lessefficientpoliciesimposeasmallerfinancial
burden on the regulated industries because they do not charge firms for
every unit of their pollution.8 These considerations suggest a conflict be-
5.AnexceptionisJorgenson,Slesnick,andWilcoxen(1992).
6.Ourmodeldoesnotincorporateadjustmentcostsforindustry-specificlabor;indeed,
laborisperfectlymobileacrossindustries.Totheextentthatlaborfacesadjustmentcosts,
oneshouldexplorecapitalizationeffectsonlaboralonglinessimilartothispaper’sexplora-
tionofsucheffectsoncapital.
7.Parry,Williams,andGoulder(1999)showthatwhileacarbontaxwithrevenuesrecy-
cledthroughcutsinmarginalincometaxratesproducesefficiencygains,reducingCO emis-
sionsthroughasystemoffreelyprovided(grandfathered)CO permitsmaybeaneffic2iency-
2
reducingproposition:Foranylevelofemissionsreduction,theenvironmentalbenefitswill
fallshortofsociety’scostsofabatement!
8.Tworevenue-raisingpoliciesareanemissionstaxandasystemofauctionedemissions
permits,wherethepermitsareinitiallyauctioned.Underthesepolicies,firmsendurecosts
ofemissionsabatementand,forwhateveremissionstheycontinuetoproduce,musteither
pay a tax or purchase permits. In contrast, under a system of freely provided emissions
48 A.LansBovenbergandLawrenceH.Goulder
tweenefficiencyandpoliticalfeasibility:Theefficientpolicy—thecarbon
tax—appearslesspoliticallyacceptablebecauseitputstoomuchofabur-
den on politically mobilized, fossil fuel industries, while the politically
moreacceptablepolicyofgrandfatheredcarbon(orCO )permitsinvolves
2
seriousinefficiencies.
Thepresentstudyfindsthatthechoicebetweenefficiencyandinsulating
profitsofkeyindustrialstakeholders(toenhancepoliticalfeasibility)may
belessproblematicthanpreviouslythought.Wefindthatdesirabledistri-
butional outcomes at the industry level can be achieved at relatively low
cost in terms of efficiency; without substantial added cost to the overall
economy, the government can implement carbon abatement policies that
protect profits and equity values in fossil fuel industries. The key to this
conclusion is that CO abatement policies have the potential to generate
2
rentsthatareverylargeinrelationtothepotentiallossofprofit.Undera
standard carbon tax policy, these potential rents do not materialize; in-
steadtheybecomerevenuescollectedbythegovernment.Incontrast,un-
der a policy involving freely allocated emissions permits, or a policy in
which some (inframarginal) emissions are exempted from a carbon tax,
firms realize some of the potential rents.9 Because the potential rents are
very large in relation to potential lost profit, the government can protect
firms’ profits and equity values in fossil fuel industries by enabling firms
toretainonlyaverysmallfractionofthepotentialrents.Thus,thegovern-
ment needs to freely allocate (as opposed to auction) only a small per-
centage of CO emissions permits or, similarly, must exempt only a small
2
fraction of emissions from the base of a carbon tax.10 Each of these gov-
permitsrequiringequivalentemissionsreductions,firmsendurethesamecostsofabatement
butdonotpayforremainingemissions.Hence,theburdenonpollutingfirmsissmaller.
9.BuchananandTullock(1975)pointedoutthatenvironmentalpoliciescangeneratesig-
nificantrentstofirmstotheextentthatsuchpoliciescauseoutputtoberestricted.They
showedthatbecauseofsuchrents,regulatedfirmscanexperiencehigherprofitsthaninthe
absenceofregulation.OurfindingsinthispaperareconsistentwithBuchananandTullock’s
analysis.FullertonandMetcalf(1998)emphasizetheimportanceofrentstotheoveralleffi-
ciencycostsofpoliciestoreducepollution.Theyindicatethatefficiencycostsaresubstan-
tiallyhigherunderpoliciesproducingrentsthatarenottaxedaway,incomparisonwithpol-
iciesthatdonotproducerentsthatareleftinprivatehands.Aparallellineofinvestigation
wasconductedbyGoulder,Parry,andBurtraw(1997),whoshowthatpoliciesthatfailto
tax away rents are at a disadvantage in terms of efficiency because they fail to generate
revenuesthatcanbeusedtoreducepreexistingdistortionarytaxes.Suchpoliciesthusfail
toexploitanefficiency-enhancingrevenue-recyclingeffect.Inthepresentstudy,weexamine
theextenttowhichpolicy-generatedrentsaffecttheimpactsofCO abatementpolicieson
2
theprofitabilityandequityvaluesofregulatedfirms.
10.Correspondingly,ifthegovernmentweretofreelyallocate100percentoftheemissions
permits,orexempt100percentofinframarginalemissionsfromthebaseofacarbontax,it
wouldgeneratesubstantialwindfallstofirms:Therentsproducedandenjoyedbyproducers
wouldbemanytimeslargerthantheincomelossesotherwiseattributabletothepolicy.The
governmentdoesnotneedtobenearlythisgenerousinordertosafeguardfirms’profitsand
equityvalues.Ourfocusontheuseofinframarginalexemptionstoaccomplishdistributional
objectivesisinthespiritofFarrow(1999),whoemploysamodelalongthelinesofBovenberg
NeutralizingAdverseIndustryImpactsofCO AbatementPolicies 49
2
ernment policies involves only a small sacrifice of potential government
revenue. Such revenue has an efficiency value because it can be used to
financecutsinpreexistingdistortionarytaxes.Sincethesepoliciesgiveup
littleofthispotentialrevenue,theyinvolveonlyasmallsacrificeinterms
of efficiency. In suggesting that the revenue sacrifice is small relative to
potentialrevenues,ourfindingscomplementthoseobtainedinapaperby
Vollebergh,deVries,andKoutstaal(1997),whoemployapartialequilib-
rium model to compare the potential tax revenues and abatement costs
thatcouldstemfromacarbontaxintheEuropeanUnion.11
Because the potential rents are quite large, it is also possible to devise
policies that, with relatively little loss of efficiency, protect not only the
fossilfuelindustries,butalsocertainindustries(suchaspetroleumrefining
and electric utilities) that intensively use fossil energy. These industries
wouldsuffersignificantprofitlossesunderastandardcarbontax.
We also find that there is a very large difference between preserving
firms’ profits and preserving their tax payments. Allowing firms to enjoy
a dollar-for-dollar offset to their payments of carbon taxes (e.g., through
industry-specific cuts in corporate tax rates) substantially overcompen-
satesfirms,raisingprofitsandequityvaluessignificantlyrelativetotheun-
regulatedsituation.Thisreflectsthefactthatproducerscanshiftontocon-
sumersmostoftheburdenfromacarbontax.Theefficiencycostsofsuch
policiesarefargreaterthanthecostsofpoliciesthatdonotovercompen-
sate firms. To maintain firms’ profits, the government needs to offer tax
reliefrepresentingonlyasmallfractionofcarbontaxpayments.12
Theremainderofthepaperisorganizedasfollows.Section2.2provides
a brief description of the numerical general equilibrium model employed
to evaluate the various policy alternatives. Section 2.3 then indicates the
linksinthemodelbetweenthevariouspolicyalternativesandfirms’profits
and equity values. Section 2.4 briefly describes the model’s data and pa-
rameters. Section 2.5 indicates the policies under consideration, and sec-
tion2.6conveysanddiscussestheresultsfromnumericalsimulations.The
finalsectionoffersconclusions.
anddeMooij(1994)withonefactorofproduction(labor).OuranalysisdiffersfromFarrow’s
in its consideration of imperfectly mobile capital and its attention to the implications of
pollution-abatementpoliciesforfirms’profitsandequityvalues.
11.Vollebergh,deVries,andKoutstaal(1997)calculatethetaxrevenuesandabatement
coststhatwouldstemfromacarbontaxsufficienttoreduceCO emissionsby13percentin
2
thecountriesoftheEuropeanUnion.Theirresultsindicatethattherevenuesfromthistax
wouldbemanytimesthepolicy-generatedabatementcosts.Thissuggeststhatexemptinga
smallshareofinframarginalemissionsfromthecarbontax(orgrandfatheringasmallshare
ofthepermitsunderapermitspolicy)wouldbesufficienttocompensatethefossilfuelsuppli-
ersinvolved.
12.FelderandSchleiniger(1999)considertheefficiencycostsofmeetingtheconstraint
thattherebeno“monetarytransfers”(i.e.,nochangeinoveralltaxpayments)asaresultof
acarbontaxpolicy.UsinganumericalgeneralequilibriummodelofSwitzerland,theymeet
thisconstraintthroughindustry-specificoutputsubsidiesorlaborsubsidies.
50 A.LansBovenbergandLawrenceH.Goulder
2.2 TheModel
Thissectionoutlinesthestructureoftheintertemporalgeneralequilib-
riummodelemployedinthisstudy.Themodelisanintertemporalgeneral
equilibriummodeloftheU.S.economywithinternationaltrade.Itgener-
ates paths of equilibrium prices, outputs, and incomes for the U.S. econ-
omy and the rest of the world under specified policy scenarios. All vari-
ables are calculated at yearly intervals beginning in the benchmark year
2000andusuallyextendingtotheyear2075.
The model combines a fairly realistic treatment of the U.S. tax system
andadetailedrepresentationofenergyproductionanddemand.Itincor-
porates specific tax instruments and addresses effects of taxation along a
number of important dimensions. These include firms’ investment incen-
tives,equityvalues,andprofits;13andhouseholdconsumption,saving,and
labor-supplydecisions.Thespecificationofenergysupplyincorporatesthe
nonrenewable nature of crude petroleum and natural gas and the transi-
tionsfromconventionaltosyntheticfuels.
U.S.productiondividesintothe13industriesindicatedintable2.1.The
energyindustriesconsistof(1)coalmining,(2)crudepetroleumandnatu-
ral gas extraction, (3) petroleum refining, (4) synthetic fuels, (5) electric
utilities,and(6)gasutilities.Themodelalsodistinguishesthe17consumer
goodsshowninthetable.
2.2.1 ProducerBehavior
GeneralSpecifications
Ineachindustry,anestedproductionstructureaccountsforsubstitution
between different forms of energy as well as between energy and other
inputs.Eachindustryproducesadistinctoutput (X),whichisafunction
oftheinputsoflabor(L),capital(K),anenergycomposite(E),amaterials
composite(M),andthecurrentlevelofinvestment(I):
(1) X = f[g(L,K),h(E,M)] − (cid:9)(I/K)⋅I.
The energy composite is made up of the outputs of the six energy indus-
tries,whilethematerialscompositeconsistsoftheoutputsoftheotherin-
dustries:
(2) E = E(x ,x + x ,x ,x ,x ),
2 3 4 5 6 7
(3) M = M(x ,x ,...,x ),
1 8 13
13. Here the model applies the asset-price approach to investment developed in Sum-
mers(1981).
NeutralizingAdverseIndustryImpactsofCO AbatementPolicies 51
2
Table2.1 IndustryandConsumerGoods
GrossOutput,
Year2000a
Level Percent
ofTotal
Industries
1.Agricultureandnoncoalmining 993.6 6.2
2.Coalmining 50.5 0.3
3.Crudepetroleumandnaturalgas 193.7 1.2
4.Syntheticfuels 0.0 0.0
5.Petroleumrefining 324.6 2.0
6.Electricutilities 234.6 1.5
7.Gasutilities 211.5 1.3
8.Construction 1508.8 9.5
9.Metalsandmachinery 799.1 5.0
10.Motorvehicles 541.2 3.4
11.Miscellaneousmanufacturing 3365.2 21.3
12.Services(excepthousing) 5183.6 32.8
13.Housingservices 2420.8 15.3
Consumergoods
1.Food
2.Alcohol
3.Tobacco
4.Utilities
5.Housingservices
6.Furnishings
7.Appliances
8.Clothingandjewelry
9.Transportation
10.Motorvehicles
11.Services(exceptfinancial)
12.Financialservices
13.Recreation,reading,and
miscellaneous
14.Nondurable,nonfoodhousehold
expenditure
15.Gasolineandotherfuels
16.Education
17.Health
aBillionsofyear2000dollars.
wherex isacompositeofdomesticallyproducedandforeignmadeinput
i
i.14Industryindicescorrespondtothoseintable2.1.
Managersoffirmschooseinputquantitiesandinvestmentlevelstomax-
14.Thefunctionsf,g,andh,andtheaggregationfunctionsforthecompositesE,M,andx,
i
featureaconstantelasticityofsubstitution(CES)andexhibitconstantreturnstoscale.Con-
sumergoodsareproducedbycombiningoutputsfromthe13industriesinfixedproportions.
52 A.LansBovenbergandLawrenceH.Goulder
imize the value ofthe firm. The investment decision takesaccount of the
adjustment(orinstallation)costsrepresentedby(cid:9)(I/K)(cid:13)Iinequation(1),
where(cid:9)isaconvexfunctionoftherateofinvestmentI/K.15
SpecialFeaturesoftheOilandGasandSyntheticFuelsIndustries
Theproductionstructureintheoilandgasindustryissomewhatmore
complex than in other industries to account for the nonrenewable nature
ofoilandgasstocks.Theproductionspecificationis
(4) X = (cid:14)(Z)⋅ f[g(L,K),h(E,M)] − (cid:9)(I/K)⋅I,
where(cid:14)isadecreasingfunctionofZ,thecumulativeextractionofoiland
gasuptothebeginningofthecurrentperiod.Thiscapturestheideathat
as Z rises (or, equivalently, as reserves are depleted), it becomes increas-
inglydifficulttoextractoilandgasresources,sothatgreaterquantitiesof
K,L,E,andMarerequiredtoachieveanygivenlevelofextraction(out-
put).Eachoilandgasproducerperfectlyrecognizestheimpactofitscur-
rentproductiondecisionsonfutureextractioncosts.16Increasingproduc-
tioncostsultimatelyinduceoilandgasproducerstoremovetheircapital
fromthisindustry.
The model incorporates a synthetic fuel—shale oil—as a backstop re-
source,aperfectsubstituteforoilandgas.17Thetechnologyforproducing
synthetic fuels on a commercial scale is assumed to become known in
2020.Thus,capitalformationinthesyntheticfuelsindustrycannotbegin
untilthatyear.
Alldomesticpricesinthemodelareendogenous,exceptforthedomes-
ticpriceofoilandgas.Thepathofoilandgaspricesfollowstheassump-
tionsoftheStanfordUniversityEnergyModelingForum.18Thesupplyof
importedoilandgasistakentobeperfectlyelasticattheworldprice.So
long as imports are the marginal source of supply to the domestic econ-
omy, domestic producers of oil and gas receive the world price (adjusted
fortariffsortaxes)fortheirownoutput.However,risingoilandgasprices
stimulate investment in synthetic fuels. Eventually, synthetic fuel produc-
tion plus domestic oil and gas supply together satisfy all of the domestic
demand. Synthetic fuels then become the marginal source of supply, so
that the cost of synthetic fuel production rather than the world oil price
dictatesthedomesticpriceoffuels.19
15.Thefunction(cid:9)representsadjustmentcostsperunitofinvestment.Thisfunctionex-
pressesthenotionthatinstallingnewcapitalnecessitatesalossofcurrentoutputbecause
existinginputs(K,L,E,andM)aredivertedtoinstallnewcapital.
16.Weassumerepresentativeoilandgasfirms:initialresourcestocks,profit-maximizing
extractionlevels,andresource-stockeffectsareidenticalacrossproducers.
17.Thus,inputs3(oilandgas)and4(syntheticfuels)enteradditivelyintheenergyaggre-
gationfunctionshowninequation(2).
18.Theworldpriceis$19perbarrelin2000andrisesinrealtermsby$5.00perdecade.
SeeGaskinsandWeyant(1996).
19.Fordetails,seeGoulder(1994,1995a).
NeutralizingAdverseIndustryImpactsofCO AbatementPolicies 53
2
2.2.2 HouseholdBehavior
Consumption, labor supply, and saving result from the decisions of a
representative household maximizing its intertemporal utility, defined on
leisureandoverallconsumptionineachperiod.Theutilityfunctionisho-
mothetic, and leisure and consumption are weakly separable (see the ap-
pendixes).Thehouseholdfacesanintertemporalbudgetconstraintrequir-
ingthatthepresentvalueofconsumptionnotexceedpotentialtotalwealth
(nonhuman wealth plus the present value of labor and transfer income).
In each period, overall consumption of goods and services is allocated
acrossthe 17specific categoriesof consumptiongoods orservices shown
intable2.1.Eachofthe17consumptiongoodsorservicesisacomposite
ofadomesticallyandforeign-producedconsumptiongood(orservice)of
that type. Households substitute between domestic and foreign goods to
minimizethecostofobtainingagivencomposite.
2.2.3 TheGovernmentSector
The government collects taxes, distributes transfers, and purchases
goodsandservices(outputsofthe13industries).Thetaxinstrumentsin-
cludeenergytaxes,outputtaxes,thecorporateincometax,propertytaxes,
salestaxes,andtaxesonindividuallaborandcapitalincome.Inthebench-
markyear,2000,thegovernmentdeficitamountstoapproximately2per-
cent of GDP. In the reference case (or status quo) simulation, the real
deficitgrowsatthesteady-stategrowthrategivenbythegrowthofpoten-
tiallaborservices.Inthepolicy-changecases,werequirethatrealgovern-
mentspendingandtherealdeficitfollowthesamepathsasinthereference
case.Tomakethepolicychangesrevenue-neutral,weaccompanythetax-
rate increases that define the various policies with reductions in other
taxes, either on a lump-sum basis (increased exogenous transfers) or
throughreductionsinmarginaltaxrates.
2.2.4 ForeignTrade
Except for oil and gas imports, imported intermediate and consumer
goods are imperfect substitutes for their domestic counterparts.20 Import
pricesareexogenousinforeigncurrency,butthedomestic-currencyprice
changeswithvariationsintheexchangerate.Exportdemandsaremodeled
as functions of the foreign price of U.S. exports and the level of foreign
income (in foreign currency). The exchange rate adjusts to balance trade
ineveryperiod.
2.2.5 EquilibriumandGrowth
Thesolutionofthemodelisageneralequilibriuminwhichsuppliesand
demandsbalanceinallmarketsateachperiodoftime.Therequirements
20.Thus,weadopttheassumptionofArmington(1969).