Incidence, environmental, and welfare effects of distortionary subsidies

Abstract

Government policies that are not intended to address environmental concerns can nonetheless distort prices and affect firms’ emissions. We present an analytical general equilibrium model to study the effect of distortionary subsidies on factor prices, pollution, and welfare. Based on real-world policies, we model an output subsidy, a capital subsidy, relief from environmental regulation, and a minimum level of labor employment that firms must agree to in exchange for the subsidies. Each policy creates both output effects and substitution effects on input prices and emissions. We calibrate the model to the Chinese economy. Variation in production substitution elasticities does not substantially affect input prices, but it does substantially affect emissions. Distortionary subsidies can both raise emissions and decrease output. Therefore, reducing distortionary subsidies can reduce emissions without a trade-off in lost output. Such opportunities arise when the subsidized sector is moderate in size.