Introduction and Motivation

The production of a ‘dirty good’ generates pollution that creates harmful effects on the health of the population, thereby lowering the efficiency of the workforce. Because the negative externalities are not internalized, the production of such a commodity should be controlled by introducing a Pigouvian production tax in order to increase social welfare. This is a standard consequence noted in the literature related to the small open economy. However, the available literature tends to assume that there are no other distortions in the economy. The simple economic argument for such an assumption is that such a tax on producers lowers production of the dirty commodity and diverts economic resources toward the production of clean commodities. The tax does not affect consumer prices, and the amount of excess demand for the ‘dirty’ commodity by consumers can be easily met through imports of the good from the international market at the given price. The tax revenue collected by the government is transferred to consumers in a lump-sum fashion. Hence, the socially optimal Pigouvian tax rate in a small open economy is unambiguously positive. Herein, we have set aside the problems relating to measurement and implementation of the tax mechanism and other alternatives to deal with ‘pollution’ and concentrate on the Pigouvian tax principle solely from the perspective of social welfare.

Two pertinent questions arise at this juncture, which are as follows: (i) is the optimal Pigouvian tax in a small open economy strictly positive even in the presence of other distortion(s), for example, labor market distortion? and (ii) does the sign of the optimal tax anyhow depend on the magnitude of negative externalities that the production of the dirty good generates?

This theoretical piece attempts to provide answers to the aforementioned questions in terms of a 2 × 2 full-employment small open-economy model with exogenous labor market imperfection. The import-competing sector (Sector 2) produces a manufacturing commodity that causes health hazards, thereby lowering the efficiency of the workers. In Sector 2, workers receive an exogenously given higher wage than their counterparts in Sector 1. Thus, we have exogenous labor market imperfection in Sector 2. In such a scenario, there is a Pigouvian production tax on the production of good in Sector 2, which aims at tackling negative externalities generated by the production of Commodity 2.