Taxation, Capital Accumulation, Environment and Unemployment in a Dual Economy Model

We develop a dual-economy growth model for agricultural and manufacturing sectors. The manufacturing sector is responsible for environmental pollution. Unemployment exists in the model, as explained by the efficiency wage hypothesis. The efficiency of a worker varies positively with the wage, unemployment rate and environmental quality–labour ratio. In the short-run equilibrium, an improvement in the environmental quality–labour ratio never affects the wage rate, the rental rate on capital or the efficiency of labour, and always raises the national income. However, it lowers (raises) the unemployment rate as well as the level of manufacturing output. It raises (lowers) the level of agricultural production when the manufacturing sector is more capital- (labour-) intensive. Second, an increase in capital stock never affects the wage rate, the rental rate on capital, the efficiency of labour or the unemployment rate but always raises national income. However, it lowers (raises) the level of output of the agricultural (manufacturing) sector when the manufacturing sector is more capital- (labour-) intensive. Capital–labour ratio stock and environmental quality–labour ratio accumulate over time. A proportional tax is imposed on the rental income on capital to finance the abatement expenditure, and household savings are invested. An increase in the tax rate raises the capital stock, national income and environmental quality but lowers the unemployment rate in the long run. Taxing capital income and using the same for environmental quality improvement is always a better policy, as it improves both environmental quality and capital accumulation.