Applied General Equilibrium Models

1. Applied General Equilibrium Models T.Huw Edwards Loughborough University

2. I refer to the Edwards and Hutton article available from Energy Economics • http://www.sciencedirect.com/science?_ob=MImg&_imagekey=B6V7G-4349WTX-2-1&_cdi=5842&_user=122878&_orig=browse&_coverDate=07%2F31%2F2001&_sk=999769995&view=c&wchp=dGLbVlb-zSkzS&md5=0c494e9609f08f4f507c2b1bb7f8fd6b&ie=/sdarticle.pdf

3. Applied general equilibrium models • These are called applied general equilibrium (AGE) or computable general equilibrium (CGE) models. • These are usually large models, which require nonlinear computing techniques to solve. • The basic principles are those of general equilibrium or welfare economics.

4. Subjects of application • CGE models are often used for studying: • Tax reforms • Trade policy (tariffs and quotas) • Energy/environmental policy (tax/permit schemes for pollutants, energy production subsidies etc).

5. The basis of a CGE model • Most CGE models start with an input output matrix

7. How the model works • For each sector, it works out total supply and demand using price and income elasticities derived from a set of underlying utility and production functions. • All of these relationships are solved SIMULTANEOUSLY for all sectors, so the effects of one sector on another are very important.

8. The matrix is basically square • This means that the size of the model is closely related to the square of the number of sectors. • If it is a multi-country model, the size of the model is related to the square of • Number of sectors x number of countries • If it is a dynamic model, the size of the model is related to the square of • Number of sectors x number of years

9. The bigger the model, the harder to compute • This explains why few people write models which are dynamic, multi-country and multi-sector. • There are important tradeoffs in terms of how complicated a model can be. No model can cover every economic effect accurately. It is necessary to choose the MOST RELEVANT bits to model in complexity (and keep the rest of the economy simple).

10. Application to Energy Demand • CGE models are widely used to study energy and environmental policy questions, such as the use of carbon tax or permit policies to cut carbon emissions. • Carbon dioxide emissions are closely linked to consumption of FOSSIL FUELS, particularly COAL (and to a lesser extent oil and gas). • One solution is to limit the amount of emission of carbon dioxide by AUCTIONING PERMITS. The price of the permit is similar to a tax on the pollution.

11. Why general equilibrium models are relevant to this question • The introduction of carbon permits has complicated interactions with other taxes and subsidies. • If you add a tax to something which already bears a heavy tax, then there is an additional welfare loss (from a reduction in revenue from the existing tax). • By contrast, if the taxed good is also being subsidised, the tax reduces the cost of the subsidy. • Some energy uses (eg transport) already carry heavy taxes. • But there are large implicit subsidies (eg due to the lack of road pricing).

12. Interaction of different fuel demands

13. Effect of carbon tax/permit upon demand for fuel f • = effect on f’s share of total energy • + f’s share x effect on total energy demand.

14. Recycling of tax revenue • This effect does require general equilibrium modelling. • A carbon permit auction would raise potentially many billions of pounds a year (depending on the permit price). This can be used to reduce other taxes.

15. Tax and demand elasticity • Deadweight loss is much bigger when demand is elastic. Harberger triangle Harberger triangle Energy demand is relatively price inelastic.

16. Since energy demand is relatively price-inelastic, welfare gains at the margin from raising the tax on energy and reducing VAT.

17. S+t0+t1 S+t0 • Interaction with a pre-existing tax S ‘First-best’ Harberger triangles Additional loss from reduced Revenue for pre-existing tax t0. ON ITS OWN, this effect can be Modelled by a partial equilibrium Model.

18. Treatment of Labour • The assumption about the price-elasticity of labour supply may have important effects upon the results of model simulations. • If labour supply curves are upward-sloping, then a reduction in VAT (which makes goods cheaper relative to leisure) will increase labour supply. • A reduction in income tax rates or national insurance will have an even bigger effect.

19. The ‘Double Dividend’ • This led some European commentators to argue that a switch from Europe’s high labour taxes to taxing energy instead could bring a ‘double-dividend’ of lower pollution and higher employment.

20. Treatment of Trade • The treatment of trade in a general equilibrium model is very important. • Generally speaking, people choose between domestically-produced and imported goods. It is usually assumed that these are IMPERFECT SUBSTITUTES. • If only some countries impose energy permits/taxes, then some production of energy-intensive goods will shift to those countries without the tax ’Carbon Leakage’

21. But a tax on energy reduces the country’s import bill. Because we assume the current account must balance, this causes its exchange rate to rise. • We call this the ‘terms of trade’ effect. Imports are now cheaper to buy, which improves welfare at home. But at the same time, the cost of your exports for foreigners rise. • This is also called a ‘tax export’ effect.

22. Example (Edwards and Hutton, 2001) • This is a model of a single country (the UK), with quite a complicated energy demand structure. • The model takes account of existing taxes on energy. It also has VAT and a simple income tax (with a flat rate and an allowance). • Import and export demand curves are downward-sloping. • The compensated labour supply curve has a positive elasticity of 0.15.

24. Both of these simulations indicate that the net cost of Kyoto compliance for the UK is almost exactly zero. • This is a very different conclusion to non-CGE studies, which ignore the effects of tax recycling. • There is almost no welfare difference between reducing VAT or reducing income tax. The latter raises employment slightly, but there is a loss of leisure.

25. Drawbacks of the model • Other models might well give different results. • They may use different elasticities, or a different sectoral structure. • They may be multi-country models, where other countries also impose the tax (imposing a terms of trade cost on the UK). But if everyone raises energy taxes, oil prices will fall (so taxes are exported to the Saudis).

26. The model is static. A dynamic model might give different results, particularly if there are adjustment costs • The model does not have macroeconomic/disequilibrium effects. Designing macro policy to accommodate a major tax shift can be tricky. • The model does not take account of the benefits of reducing other pollutants, and of reduced transport congestion. These can be sizeable.

27.  THERE IS NO PERFECT MODEL!