Environmental Tax Reform in a Federation with Rent-Induced Migration

We study the welfare effects of a revenue-neutral environmental tax reform in a federation. The reform consists of increasing a tax on a polluting input and reducing that on labor income. Households are fully mobile within the federation. Regions are unequally endowed with a nonrenewable natural resource. Resource rents are owned by regions and are redistributed to citizens on a residence basis, which generates a motive for inefficiently relocating to the resource-rich jurisdiction. Since the resource-poor region has a higher marginal product of labor than does the resource-rich region in equilibrium, the tax reform mitigates the scope of inefficient migration if labor and the natural resource are complements, but exacerbates it if they are substitutes. This welfare effect may significantly affect fiscal costs of pollution pricing and calls for an adjusted environmental tax, higher when inputs are complements, lower when they are substitutes, as compared with a model where migration is assumed away.