Welfare Analysis Of Controlling Indoor Air Pollution (The Case Of Urban Ethiopia)

Thus, mainly this paper focuses onintroducing welfare analysis by taking a single policy measure, which helps to controlindoor air pollution.This study by using the marginal tax reform a

WELFARE ANALYSIS OF CONTROLLING INDOOR

AIR POLLUTION(THE CASE OF URBAN ETHIOPIA)

By: Wondwossen Tsegaye Aselet

E-mail: wendsentsgay@yahoo.com

Page

Abstract

CHAPTER ONE

Introduction

1.1Bakground……….4

1.2 Statement of the Problem……….5

1.3 Significance of the Study……….6

1.4 Objectives of the study……….7

CHAPTER TWO Literature Review 2.1Theoretical Literature………9

2.2 Empirical literature……… ……….15

CHAPTER THREE Methodology of the study 3.1 Model Specification……… 18

3.2 Data collection……… 22

CHAPTER FOUR Empirical Results……….23

CHAPTER FIVE Summary and Conclusion……… 25

References

Abstract

The main reason for the failure of many policy measures in developing countries is thefact that interaction of different social as well as economic activities are not taken in toconsideration before they are being implemented It is important that governments inthese countries should focus on addressing welfare, environmental and social aspect oftheir policy measures before implementing them Thus, mainly this paper focuses onintroducing welfare analysis by taking a single policy measure, which helps to controlindoor air pollution.

This study by using the marginal tax reform approach attempts to analyze the welfareeffect of indoor air pollution control in urban Ethiopia No study has been done regardingthis issue, thus the study tries to show one way of analyzing welfare on theimplementation of pollution-controlling-policy instrument Hence, the 2000 urbanhousehold socio-economic data collected by the Department of Economics of the AddisAbaba University is used in order to identify goods that are heavily concentrated in theconsumption of poor households

Accordingly, the study found that introducing or increasing tax on commodities whichare the main sources of air pollution (kerosene, charcoal) would affect the welfare of theurban households as the consumption of these commodities are more concentrated onpoor than rich households Differently, the study has found that a tax increase orintroduction on commodities such as fuel wood and Cigarettes would not have asignificant welfare loss for the urban society

CHAPTER ONE

I Introduction

1.1 Background

There are three broad sources of air pollution from human activities; stationary or point,mobile, and indoor air polution (Kathuria, V 2001) Industries, power plants, etc are thecauses of stationary air pollution, where as indoor air pollution refers to pollutions fromopen fires for cooking and heating It is mostly a problem in developing countries, and itseffect become intense in rural areas Mobile or Vehicular air pollution is particularly aserious problem in urban areas.

Since most economic activities or transactions are concentrated in urban Ethiopia, the airpollution that resulted from these three sources is a serious problem However, it seemsthat, in Ethiopia, compared to other developed countries, there is no serious problemrelated to air pollution But this is only because of the fact that no body gives a seriousattention to the effects of air pollution Moreover, there is no study or reliable dataregarding the effects of air pollution on the health condition of the people living in thecountry In now days, in Addis, vehicles are increasing alarmingly Ethiopians (mostlystudents and trainees), who have been in other western countries, have a legal- right toimport any cars from the country where they have been Following this legal- right most

of them import second hand cars (old cars) It is known that these vehicles contributemuch for air pollution than the new ones However from the government side there is nomeasure taken to regulate or decrease the importation of these polluting vehicles

Indoor air pollution, which is mostly ignored by the people affected by and government

as well has a serious effect on the health of children as well as residents in the house Inurban areas of Ethiopia, where large part of the population is using fuel wood, charcoals,and kerosene for cooking purposes in their daily life, it is unreasonable to ignore the airpollution that results from these burnings Almost more than 85 % of the people in urbanareas of the country use fuel wood, charcoals and kerosene for cooking as well as forother daily activities Thus the contribution of this process to the environment pollutionshould not be treated as insignificant Nevertheless, controlling the air pollution resultingfrom these sources is also a problem in connection with their effect on the livingcondition of the people For instance, taxing or charging these commodities is onemethod of controlling the air pollution by discouraging the consumption of these

commodities But, since the consumption of these commodities may be moreconcentrated on poor households than the rich ones the effect of taxing or charging thecommodities should be analyzed first.

I.2 Statement of the Problem

Policies that affect consumer and producer prices have an impact on welfare According

to Duclos et al (2000), most governments use indirect taxes; mainly VAT, to raise taxrevenues thus affecting consumer and producer prices An increase or a decrease in thetax of a good will have an effect on producer or consumer prices and this in turn wouldentails a decline or an improvement in the welfare of an individual Policy analysts mustroutinely evaluate the impact of such polices on social welfare

Marginal social cost of revenue from the tax on a particular good depends on the rate atwhich household welfare falls as the tax rate increases, and on the rate at which publicrevenue rises (Ahmad and Stern 1984) If many people consume more of a particulargood and the less responsive is government revenue to a tax increase, then policy makersshould focus on decreasing the tax rate on that good

If any reform of indirect taxes is to be welfare improving, it requires detailed empiricalanalysis In Ethiopia, where per capita income is one of the lowest in the world, indirecttax reform should not only focus on targeting higher revenue, but the tasks of tax reformshould also include analyzing whether the directions of the reform would not aggravatethe poverty of the people

In almost all developing countries, the livelihood of the society is dependent on productsthat are obtained from the environment Based on this fact, it could be argued that there is

a need to control for the rapid environmental deprivation, such as reduction in air quality,deforestation, soil degradation and noise pollution Nevertheless, In these countries,where most part of the population is living under the poverty line, environmental assetsprotection only may not be the crucial thing that government should focus on, rather

government or policy makers should also give due emphasis for the improvement of theliving condition of the society

In this regard, the study attempts to demonstrate empirically the possible welfare impact

of introducing tax on indoor pollution sources (fire wood, kerosene and charcoal) Hence,the main task of this paper is to pave a way for making welfare analysis before any taxpolicy instrument is used for controlling negative environmental impacts Thus, thepaper, specifically, focuses on making welfare analysis on an increase or decrease of tax

or charge on indoor air pollution sources (fuel wood, kerosene and charcoal) bycalculating the distribution characteristics of these commodities The study attempts tomeasure the distributional characteristics, which reassure how heavily the consumption ofeach good is concentrated on the poor This measure helps to answer which item shouldhave to have a tax increase or a tax decrease on the ground of distributional equity andpoverty alleviation it also helps to identify goods that are good candidate for introducing

a new tax

1.3 Significance of the Study

Ahmad and Stern (1991) have pointed out that the main purpose of taxation is to

raise resources to finance government expenditure They underline the problem of taxdesign as one of finding a way of raising resources in a manner which is administrativelyand politically feasible and which promotes equity and efficiency

In a similar vein, a recent publication by the IMF (cited in Islam 2003) notes thattaxation creates distortions and the main objective of tax policy is to design a system thatraises enough revenue while minimizing the level of associated distortions Ethiopia is currently implementing a Tax Reform Program, which includes thereplacement of single stage sales tax by Value Added Tax (VAT) The indirect taxreform mainly focuses on raising more revenue, facilitating the economy andmodernizing the tax administration However, little is known about the likely effects ofthe tax reform on the welfare of the society Despite its significance, no study has beendone in analyzing the welfare effect of a tax reform in Ethiopia

In Ethiopia, particularly in urban areas, air pollution is increasing surprisingly Thoughthere is no reliable figure of the effects of air pollution on health, it would not be difficult

to see that air pollution is a serious problem in urban areas In Ethiopia, where Per CapitalIncome of the population is below the thresholds that people should have for a living, itseems ridiculous to discus environmental issues This is because of the fact that no bodygives attention to the effects of pollution, rather they prefer to focus on how to improvetheir living conditions No study has been conducted regarding the welfare effects of airpollution in urban areas Hence the paper is a pioneer by attempting to investigatewhether applying policy instruments, particularly; tax policy to decrease air pollution inthe urban Ethiopia would lead to welfare gain

This study by using marginal tax reform approach introduces for the first time howwelfare analysis should be done before policy instruments are applied for the purpose ofcurbing environmental damage This would help especially the governments indeveloping countries to check first the effect of the policy on the welfare of the societyand tries to compare whether the gain from the implementation of the environmentalpolicy does compensate the welfare loss Hence, this study by showing the need to makewelfare analysis before implementing any policy for the purpose of controllingenvironmental hazards, addresses the issue of streamlining economic development withenvironment

1.4 Objectives of the Study

The main objectives of the paper are:

 To see empirically the welfare effects of controlling indoor airpollution in urban Ethiopia Hence, the paper tries to investigatewhether an attempt for controlling air pollution using taxation orcharging the source may result in welfare loss of the people.Thiswould be done by identifying goods whose consumption is moreheavily concentrated on poor households

 The paper attempts to introduce ways of analyzing welfare in anattempt of controlling negative environmental impacts, particularly airpollution.

 To identify or recommend other ways of controlling indoors airpollution, which may not result in serious welfare loss for the society

CHAPTER TWO

In welfare economics the starting point for measuring welfare is the utilityfunction (Glewwe and Twum 1998) It asserts that welfare rises as the consumption ofvarious goods and services increases But, most consumption and household data arecollected at the household level and thus require analysis using a household level utilityfunction rather than individual Hence one should assume:

i) A household’s utility is a function of the consumption of goods and services andthe composition of household members The composition is needed to account forthe fact that house holds with different compositions require differentconsumption levels to attain the same level of welfare (for example, house- holdswith large number of members need more goods and services to attain the samewelfare level as households with small household size

ii) Each household possesses the same household utility function in order to compare

the welfare of different households If they posses different welfare function itwould be impossible or meaning less to compare welfare among differentcategories of people

iii) Since one does not know the distribution of welfare with in the household, one

has to assume that all household members enjoy the same level of welfare(Glewwe and Twum 1998)

When government wants to impose an indirect tax on a commodity it may bebetter first to find out whether such tax may not significantly increase the price of thecommodity and therefore substantially reduce the welfare of people Similar informationmay be needed with respect to imposition of indirect tax on commodities This

necessitates a welfare measure that could help governments or policy makers in theirdecision on the policy measures

Several welfare measures have shown great progress in the last twenty-five years

Consumer Surplus: It is the difference of the total amount that an individual is willing

to pay and the amount he actually pays Consumer surplus is used to measure individualwelfare and social welfare based on its unweighted sum over the population.According to Slesnick (1991), consumer surplus is the overwhelming choice as awelfare indicator, because it is an intuitive concept with modest data requirement.Slesnick (1991) has shown that in the simplest case of a change in the price of a singlegood say, a commodity from P0 to P1 , the change in consumers surplus simply is thenegative of the change in the area under the demand curve

0

P

1 CSk= ∫ x1(t,p2 pn,Mk,Ak) dt

1

P

1

Where Mk= the level of expenditure of the kth household

P= (P1,P2, Pn) is a vector of prices

Ak= is a vector of demographic characteristics

Xi (P1,Mk,Ak) = the demand function for good i

The use of Marshallian consumer surplus as a measure of welfare change is problematicfor the following reasons

i) It works only for one price change If several price changes or price and

income changes, we need a more potent approach for estimating the welfareimplication

ii) Even for the case of a single price change Marshallian consumer surplus, as a

measure of welfare change is problematic on account of maintaining themarginal utility of income as constant

The validity of consumer surplus as welfare measure has been questioned andJohn Hicks developed two approaches to welfare measurement, which do not have thesame shortcomings as consumer surplus.

These two welfare measures are (Creedy 1999):

Compensation Variation (CV): It is the amount of money that must be given to

a loser, or taken from a gainer in order to keep the individual on the initial indifferencecurve If prices change from Po to P1 as a result of the imposition of indirect taxes thenindividual utility changes from Uo to U1 (after the associated change in consumption)

In terms of the expenditure function E(P,U) it can be written as:

CV = E (P1, Uo) – E (Po, Uo)

Equivalent Variation (EV): is the amount of income that must be given to the

consumer in the initial situation in order to attain a new (higher) indifference curve.Equivalently, it can be thought of as the minimum amount of income the consumerwould be willing to accept in order to forgo the move from the status quo to the newsituation

EV=E (P1, U1) – E (Po, U1)The Hicksian demand function (XiH (P,U) ) can be obtain from the expenditure function

XiH (P,U) = ∂E (P,U)

∂PiThe welfare changes defined by compensating and equivalent variation are represented

by areas to the left of the Hicksian demand curves between price Pio & Pi1, for Uo and

Robert Willig made the first attempt to tackle this problem by demonstrating that, “inthe case of a single price change, (observable) estimates of consumer’s surplus can be

used to provide a good approximation to the equivalent or compensating variation.Since these welfare indicators provide upper and lower bounds for consumer’s surplus,the accuracy of the approximation depends on the magnitude of the income effect”.(Slesnick 1991, p 2112)

2.1.2 Marginal Tax Reform Approach

Tax reform, as defined by John and Smolensky (1994), may take variety offorms It can cover increase or decrease in tax rates, brackets or thresholds and changes

in the tax base, the introduction of new taxes and the abolition of new taxes, andchanges in the tax mix Tax reform loosely speaking deals with improving welfare bymaking marginal changes in tax design and structure

The theory of tax reform is concerned with small departure from an

existing tax structure The marginal tax reform method, pioneered by Feldstein (1972)and extended by Ahmad and Stern (1984), involves comparing for each commodity, themarginal change in social welfare arising from a tax change with the small change in totaltax revenue Newberry and Stern (1987) have tried to make clear the theory of marginaltax reform According to them the theory shows that the social welfare effect of amarginal tax change is given by the weighted sum of each household’s consumption ofthe good The weight reflects the social marginal value of consumption by eachhousehold “The social welfare impact of a tax or price change therefore depends on thetotal level of consumption of the good and (if social weights differ across households) thedistribution of that consumption amongst the population” (Gibson 1998, pp 4)

Deaton (1997) contrasts this view with the theory of optimum taxes The

optimal tax theory, as explained by Deaton, focuses on the prices that maximize a

social welfare function subject to budgetary behavioral constraints That is, it is aconstrained optimization of a social welfare function by the social planner, given therevenue constraint, available tax instruments and the influence of these instruments onprivate behavior It provides a systematic and essential framework for thinking about thestandard issue of distribution and economic efficiency that are the basis for anyintelligent discussion of price and tax reform

The main criticisms against optimal tax theory are as follows:

(i) The model could not describe the social and political equilibrium that exist in

developing countries, because of its unrealistic assumptions (Deaton 1997)

(ii) Calculation of optimal indirect tax rates requires a great deal of data about

preferences and demand patterns (Creedy 1999)

The theory of marginal tax reform solves the above problems faced by the

optimal tax theory Especially its limited data requirement makes it easy to apply even indeveloping countries In real life it is rarely possible to reach optimal tax rateimmediately Thus, its practical applicability attracts policy makers in analyzing a taxsystem using marginal tax reform approach This paper mainly follows this approach inanalyzing the direction of the tax reform in Ethiopia

The approach to the analysis of marginal indirect tax reform is based on the use

of social welfare function representing the value judgments of a decision maker or judge The social welfare function (w) is a function of the individual welfare value u,which, in turn is given by the value of the indirect utility functions that gives themaximum attainable welfare in terms of prices (p) and outlays (yh)

Uh = φ (yh, p)

W = V(u1, u2,….uN)

A simplistic model of price determination assumes that the consumer price

is the sum of a fixed price and the tax or subsidy (Deaton 1997), so that

Pi = pio + ti

Where ti = tax Government revenue is the sum over all goods and all households of taxpayments:

R = Σ Σ ti qih

Where qih = amount of good i purchased by household h and there are M goods inall

The theory assumes that;

i) A change in the tax rate is equivalent to a change in the price

ii) Any change in the tax or price is fully transferred or passed on to

A given change in the tax rate will produce a large revenue effect, the greater isthe aggregate consumption of a good and the less the substitution away from the taxedgood

The welfare effect for marginal tax change is given by the weighted sum of eachhousehold’s consumption of the good

Ch = consumption level for household h e= coefficient of inequality aversion

With this social welfare function, the social weight applied to consumption byhousehold h is given by the social marginal utility of consumption

Bh = (Ch) -e

“Different values of the coefficient e reflect different judgment about the

desirability of making transfers to reduce income inequality Because of this, a range

of values for e is commonly used to see whether conclusions are robust to practical

ethical judgments” (Ahmad and Stern 1991) The source of behavioral estimates of e isthe information contained in the patterns of private transfers between households Anincrease in the inequality aversion parameter (e) would imply an increasing weighttoward the consumption of the poor

h = 1 H

Therefore, the cost - benefit ratio of tax is:

λi = ∂W /∂ti

∂R/∂tiWhere ∂w/∂ti =the change in welfare with a marginal increase in tax

∂R/∂ti = the change in revenue with a marginal increase in the tax rate

After substituting the value of ∂W/∂ti and ∂R/∂ti we get;

II.2 Empirical Literature Review

As it has been explained in the above discussion, since this study is a pioneer inattempting to use the marginal tax reform approach for the purpose of analyzing welfareimpact of applying pollution controlling policy instruments, the empirical literaturesmay not directly related to the objective of this paper In spit of this, it is better to raisesome studies that have been made using marginal tax reform approach

Ahmad and Stern (1984) have developed the theory of marginal tax reform and

empirically tested for India They found that λi (the social cost to benefit ratio) for cerealsranks lower than that of all other commodity groups with the exception of milk and milkproducts This suggests an increase in tax on cereals relative to the other groups and adecrease in the tax on the clothing group relative to all others

j = 1

H

∂R/∂ti

H

j = 1