Turkey Green Growth Policy Paper: Towards a Greener Economy
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Annex 1: Description of the Algebraic Structure of the CGE ModelThis is an overview description of the properties of the computable general equilibrium (CGE) model to be utilized as a laboratory device to investigate various alternative scenarios of policy intervention and technical change as pertain to the medium-long term growth of the Turkish economy. The CGE approach, compared with other modeling techniques (such as linear programming or input-output analysis) for environmental policy evaluation proves more attractive with its ability to trace the relationship between production costs, their relevant technologies, consumer choices, and interaction of the green policy instruments with the fiscal and foreign trade policies throughout the economy in an internally consistent way. The model is in the Walrasian tradition with optimizing agents against market signals and a simultaneous resolution of market equilibrium of commodity prices, the wage rates and the real rate of foreign exchange. “Dynamics” into the model is integrated via “sequentially” updating of the static model into a medium-run of twenty years from 2010 through 2030. Economic growth is the end result of (i) rural and urban labor population growth; (ii) investment behavior on the part of both private and public sectors; and (iii) total factor productivity (TFP) growth performance of the Turkish economy. The supply-side of the economy is modeled as twelve aggregated sectors. In line with our focus on strategic industrial sectors and environmental policy evaluation, the disaggregation scheme develops into the energy sectors and critical sectors of GHG and Particular Matter (PM10) pollutions in detail. It thus aggregates a large number of other activities that, although being far more important contributors to total gross output, are not germane to the strategic growth and greening problem. The sectors that we specify are:
Labor, capital and a composite of primary energy inputs, electricity, petroleum and gas and coal, together with intermediate inputs are the factors of production. For modeling agricultural production activities, the model further accommodates rainfed and irrigated land as additional factors. Water and fertilizer use (nitrate and phosphorus) are explicitly recognized as part of land usage in rural production. Basic Features of the Model The model is in the tradition of applied general equilibrium paradigm where the production-income generation-consumption and saving-investment decisions of an economy are depicted within a market equilibrium setting. Optimizing economic agents are modeled as responding to various price signals as affected by a range of government’s taxation/subsidy policies. The economy is modeled to operate in an internationally open environment where exchange rate and foreign capital inflows interact with exports and imports of the domestic sectors. Emissions arising both from production activities and from consumption activities are modeled within the specification of the dynamics of the circular flow of the economy. Sectoral production is modeled via a multiple-stage production technology where at the top stage, gross output is produced through a Cobb-Douglas technology defining capital (K), labor (L), intermediate inputs –excluding primary energy inputs (ID) and primary energy composite (ENG) as factors of production. In agriculture, in addition to these, the model accommodates land aggregate as an additional composite factor of production. Agricultural land aggregate is further decomposed as a constant elasticity of substitution (CES) function of irrigated and rain-fed land. This decomposition is responsive to rental rates of the type of the land respectively, which are solved endogenously by the model. Water used in irrigated land is set as a Leontief coefficient. Fertilizer use is similarly modeled as a Leontief technology as a ratio of aggregate and used. In algebraic terms, for the non-agricultural sectors the production technology is given as follows:
i = CO, PG, RP, EL, CE, IS, MW, ET, AU, CN, OE where as in agriculture, production entails land aggregate as an additional factor of production:
In Equations 1-i and 1-ii, AX is the technology level parameter,  ,  ,  ,  denote the shares of capital input, the labor input, aggregate land input (only for agriculture) and the energy input in the value of gross output in sector i. Under the assumption of constant returns to scale (CRS) technology, for every sector i:
These relationships are further portrayed in Figure 6.1 (in main text –chart which summarizes flows of commodities, factors and emissions in the model). At the lower stage of the production technology, the primary energy composite is produced along a constant elasticity of substitution (CES) production function using the primary energy inputs, coal, petroleum and gas and electricity:
Under the above production technology, differentiation of the minimum cost per unit of primary energy inputs gives the sectoral demand for coal, petroleum and gas and electricity:
Where, PEG is the cost of energy input composite, and CO2taxNj and PM10taxNj are the pollutant’s fees (carbon, and particular matter-10 tax rates, respectively) on input j. Sectoral demands for labor, capital, and energy composite and intermediate inputs arise from the profit-maximization behavior of the representative firm in each sector:
The equations above governing demand for both primary energy inputs and the other factors of production already provide some indication on the effects of alternative policies on the supply-side of the economy. A tax on the usage of coal for instance, (CO2taxNCO + PM10taxNCO) would shift the demand away from coal as a primary source of energy towards other sources, under the allowances of substitutability determined by the production technology. In agriculture, the land aggregate is demanded in relation to its factor intensity as above:
where RNA is the average land rental rate. This average is obtained from the weighted average of the rental rates on irrigated land and rain-fed land: RNA NA = RNRF(1+taxF)NRF + RNIR(1+taxF+feeW)NIR (11) In equation (11) RNRF and RNIR refer to rental rates of the rain-fed land, NRF, and irrigated land, NIR, respectively. The fee rates are on fertilizer use (taxF) and on water usage (feeW). At a lower level, land aggregate is a CES composite of the irrigated and rain-fed land types:
The optimal choice of the farmer towards utilization of irrigated versus rain-fed land is given from the optimizing conditions and is subject to the taxation (fees) instruments:
It is assumed that the amount of water usage in irrigation is given by a Leontieff coefficient on the irrigated land: IRWD = w NIR (14) Likewise, fertilizer usage is modeled as a fixed ratio of the aggregate land: FRTD = € (NIR + NRF) (15) The water and fertilizer usage are to be affected by fee/subsidy instruments (taxF and taxW) as introduced above. In the land markets, the rental rates of the irrigated and rain-fed land types are determined by contrasting the land demand against the available supply.
The model specifies a dualistic structure in the labor markets where rural and urban labor forces are differentiated. Rural labor market wages are fully flexible and the low productivity problem is revealed in low wages. Urban labor market is subject to nominal wage fixity and an endogenous unemployment mechanism is generated. Within inter-temporal dynamics, rural labor migrates into urban centers via a simple Harris-Todaro framework with migrants responding to expected urban wage rate and rural wage differences. With this mechanism we try to capture some of the key historical adjustment characteristics of the Turkish growth patterns via effectively unlimited supplies of rural labor. This mechanism will also be explanatory in portraying a basis for the analysis of rural poverty issues. The amount of rural labor migrating to the urban labor market is found by:
where WAG is the rural labor wage rate (flexible), and EWU is the expected urban wage rate.  is an elasticity parameter used to control the responsiveness of the migration decision in response to the wage differentials. The expected urban wage rate is a weighted average of the (nominally fixed) urban wage rate and the sectoral employment levels in the urban sectors:
Given the migrated labor and supplies of both types of labor, urban labor market is quantity adjusting via unemployment:
Rural labor market wages are flexible and agriculture sector is at full-employment:  (21)
Likewise, given the aggregate physical capital stock supply in each period, the capital market equilibrium, Environmental Pollution and Instruments of Abatement We will distinguish two types of environmental pollution: gaseous emissions (in terms of CO2 equivalents and PM10) and waste generation. Waste is thought to be in “solid” and “water” discharge form and is generated from
On the other hand, three basic sources of CO2 and PM10 emissions are distinguished in the model: (i) due to industrial processes, (ii) due to (primary and secondary) energy usage, and (iii) due to energy use of households. Total gaseous and PM10 emission in the economy is the sum over from all these sources:
Depending on the source of emission, we assume different allocation mechanisms of carbon dioxide. Following Gunther et al. (1992), the emissions from industrial processes is regarded to depend on the level of industrial activity, therefore is hypothesized proportional to gross output:  =  (22-i)
Total emissions due to energy usage, TOTCO2ENG are generated from two sources: sectoral emissions due to combustion of primary energy fuels (coal and petroleum and gas) and sectoral emissions due to combustion of secondary energy fuels (refined petroleum): TOTCO2ENG =  (23)
Under both sources, the mechanism of emission is dependent on the level of pollutant-emitting inputs (energy input at primary and at secondary levels) in each sector:  =  IDj,i j = CO, PG (24)
 =  IDji j = RP (25)
Total emission of CO2 in the use of energy by households is given by:  (26)
where, Pollutant tax/fee can serve as one of the instruments and is thought to be introduced at per tons of carbon dioxide emitted, on production, on intermediate input usage and on consumption respectively. The revenues are directly added to the revenue pool of the government budget.
PM10 emissions are modeled in the same manner, with the corresponding fee/tax rate as:
Income Generation and Demand Private sector is aggregated into one household. Household income comprises returns to labor input, net of social security taxes, and land rental income. Household income is further accentuated by remittances of profits from the enterprise sector. W*LG,J corresponds to the transfers from the green wage fund (as defined in Box 6.2, Equation 1:
The net profit transfer of the enterprise income to private household is mainly composed of returns to capital as a factor of production: EtrHH = (1-  ) - EERPtrROW - NFIG + GtrEE -  + (30)
Here, a constant proportion trrow, of the total profit income is distributed to the rest of the world to represent the net factor income of foreigners in Turkey: EERPtrROW =  (31)
In Equation 31, GtrEE is the net transfers of the government to private enterprises, rDDomDebtG is the interest income of the enterprises (banking sector) out of government domestic debt and rFForDebtE is the interest payments of the private enterprises for their already accumulated foreign debt. As e represents the exchange rate variable, ForBORE is the new foreign borrowing of the private sector in foreign exchange terms. Finally, the primary sources of income, together with the secondary sources of income constitute the total private income to the household:
In the equation above, GtrHH is government transfers to private households and SSItrHH is the social security institutions transfers to the households. ROWtrHH represents remittances. Private disposable income, is then private income of the households, net of income taxes:  (33)
Private household saves a constant fraction, sp of its income. The residual aggregate private consumption then is distributed into sectoral components through exogenous (and calibrated) shares:  (34)
where PCi is the composite price of product i which consists of the unit prices of domestic and foreign commodities, united under the imperfect substitution assumption through an Armington specification. Likewise, aggregate public consumption is distributed into sectoral production commodities in fixed proportions:  (35)
It is assumed that the aggregate public consumption is specified to be a constant fraction of aggregate public income:  (36)
where GREV represents public revenues. GREV composes of direct taxes on wage and profit incomes and profit income from state economic enterprises. The income flow of the public sector is further augmented by indirect taxes on domestic output and foreign trade (net of subsidies), sales taxes and environmental taxes: 
+ TOTAL Environmental Taxes (37) The set of environmental tax/fee instruments are tabulated in Table 6.1 (see main text). The model follows the fiscal budget constraints closely. Current fiscal policy stance of the government is explicitly recognized as specific targets of primary (non-interest) budget balance. We regard the government transfer items to the households, to the enterprises and to the social security system as fixed ratios to government revenues net of interest payments. Then, under a pre-determined primary surplus/GDP ratio, public investment demand is settled as a residual variable out of the public fiscal accounts. The public sector borrowing requirement, PSBR then, is defined by PSBR = GREV – GCON –GINV - rPGe ForDebtG - rDDomDebtG –GtrHH – GtrEE – GtrSSI (38) and is either financed by domestic borrowing, ΔDomDebtG or by foreign borrowing ΔeForDebtG. General Equilibrium The overall model is brought into equilibrium through endogenous adjustments of product prices to clear the commodity markets and balance of payments accounts. With nominal wages being fixed in each period, equilibrium in the labor market is sustained through adjustments of employment. Given the market equilibrium conditions, the following ought to be satisfied for each commodity i:
that is, the aggregate absorption (domestic supply minus net exports) of each commodity is demanded either for private or public consumption purposes, private or public investment purposes or as an intermediate good. The model’s closure rule for the savings-investment balance necessitates:
PSAV + GSAV + e CAdef = PINV + GINV (40)The CAdef in the equation above determines the current account balance in foreign exchange terms and equals to the export revenues, the remittances and private and public foreign borrowing on the revenue side and the import bill, profit transfers abroad and interest payments on the accumulated private and public debt stocks on the expenditures side:  (41)
The private and public components of the external capital inflows are regarded exogenous in foreign exchange units. The additional endogenous variable that closes the Walrasian system is the private investments, PINV. Finally, the exchange rate e, serves as the numeriare of the system. Dynamics The model updates the annual values of the exogenously specified variables and the policy variables in an attempt to characterize the 2010-2030 growth trajectory of the Turkish economy. In-between periods, first we update the capital stocks with new investment expenditures net of depreciation. Labor endowments are increased by the respective population growth rates. Similarly, technical factor productivity rates are specified in a Hicks-neutral manner, and are introduced exogenously.54 Urban nominal wage rate is updated by the price level index (PINDEX)55 which is endogenous to the system. Finally, at this stage we account for the evolution of debt stocks. First, government’s foreign borrowing is taken as a ratio to aggregate PSBR:
Thus, government domestic borrowing becomes: DomBor = (1 – gfborrat) PSBR (43) Having determined the equations for both foreign and domestic borrowing by the government, we establish the accumulation of the domestic and foreign debt stocks of the public sector: DomDebtt+1 = DomDebtt + DomBort (44) ForDebtGt+1 = ForDebtGt + ForBorGt (45) Similarly, private foreign debt builds up as: ForDebtPt+1 = ForDebtPt + ForBorEt (46) TFP increase is one of the drivers of growth; various assumptions held in greening scenarios are detailed in Box 6.2 and 6.4. In the reference scenario, TFP growth is specified as:  (47)
Capital and labor growth follows standard specification as:  (48)
 (49)
Definition of Model Variables and Parameters ENDOGENOUS VARIABLES INDICES i Commodity j Sectors (12) G Green activites SS Strategic sectors T Time
A Agriculture sector N Land
ID Intermediate input E Energy
Prod Producer P Private F Foreign D Domestic CO Coal PG Natural gas EL Electricity EXPONENTS G Government M Imported E Exported S Supply D Demand
INM Non-energy inputs ENG Primary energy inputs IND Industry linked
IRW Irrigated land FRT Demand for fertilizer RNIR Rental rate of irrigated land RNRF Rental rate rain-fed land LSUPURB Labor supply urban LSUPA Agricultural labor NA Demand for land Specific tax variables are summarized in Table 6.1. ENVIRONMENTAL POLLUTION AND CO2 TAXES CO2EMi CO2 Emissions CO2 Emissions caused by non-primary energy input usage
CO2 Emissions caused by combustion of primary energy inputs
CO2 Emissions caused by industrial processes
TOTCO2ENG Total CO2 Emissions from Primary and Non-primary Energy Input Usage TOTCO2IND Total CO2 Emissions from Industrial Processes TOTCO2HH Total CO2 Emissions from final private consumption by households TOTCO2 Total CO2 Emissions CO2tNj CO2 Tax Rate on Intermediate Input Use of j CO2tP CO2 Tax Rate on Sectoral Output CO2tCj CO2 Tax Rate on Private Consumption good i TOTCO2TAX Total CO2 Emissions Tax TRADE BLOCK CCi Composite Tradable Good DCi Domestically Produced Good Ei Exports Mi Imports INCOME GENERATION AND DEMAND BLOCK EtrHH Enterprise Profit Transfers to Households EERPtrROW Profit Transfers Abroad NFIG Net Factor Income from Enterprises to Government YHWnet Private Household Net Labor Income YHnet Net Private Income (Private Disposable Income) YHH Private Income PUBLIC SECTOR BALANCES GREV Public Revenues GPRMBAL Primary Budget Balance GTrans Government Transfers GCON Public Consumption GtrHH Government Transfers to Households GtrEE Government Transfers to Enterprises GtrSSI Government Transfers to Social Security Institutions revSSI Revenues of Social Security Institutions SSItrHH Social Security Institution Transfers to Households FINANCIAL ACCOUNTS PSAV Private Savings GSAV Government Savings ForDebtG Government Foreign Debt Stock DomDebtG Government Domestic Debt Stock ForBorG Government Foreign Borrowing SECTORAL DEMANDS PRIVCON Private Consumption PINV Private Investment GINV Public Investment CDi Private Consumption GDi Government Consumption IDPi Private Investment Demand by Sector of Origin IDGi Government Investment Demand in Sector (i) MARKET CLEARING INTi Intermediate Input Uses CAdef Current Account Deficit GDP Gross Domestic Product EXOGENOUS VARIABLES AND PARAMETERS PRICE BLOCK  World Price of Imports
 World Price of Exports
pwtsi Price Weights  Import Tariff
 Export Tax Rate
 Sales Tax Rate
OUTPUT AND FACTORS OF PRODUCTION BLOCK  Nominal Wage Rate of Formal Labor
 Total Formal Labor Supply
 Total Formal Capital Supply
AXi Production Function Shift Parameter  Cobb-Douglas Production Function Capital Share Parameter
 Cobb-Douglas Production Function Formal Labor Share Parameter
 Cobb-Douglas Production Function Intermediate Good Share Parameter
 Cobb-Douglas Production Function Energy Share Parameter
 Production Tax Rate
AEi Primary Energy Composite Production Function Shift Parameter  Primary Energy Composite Production Function Coal Share Parameter (j =CO, PG, EL)
 Primary Energy Composite Production Function Exponent
ENVIRONMENTAL POLLUTION AND CO2 TAXES Coefficient for emissions created by non-primary energy intermediate input usage
Coefficient for emissions created by primary energy intermediate input usage
 Coefficient for emissions created by industrial processes
 Coefficient for emissions created by final private consumption
TRADE BLOCK  CET Function Shift Parameter
 CET Function Share Parameter
 CET Function Exponent
 Armington Function Shift Parameter
 Armington Function Share Parameter
 Armington Function Exponent
Import Tariff rate
Export Tax rate
INCOME GENERATION AND DEMAND BLOCK trrow Profit Transfers abroad ratio shrgi Government Profit ratio tCorp Corporate Tax rate tInc Income Tax rate ROWtrHH Workers Remittances Various pollution fees and taxes are summarized in Table 6.1 in Vol1. PUBLIC SECTOR BALANCES prbrat Primary Balance Ratio (of GDP) gcr Government Consumption Ratio (of non-interest expenditures) gtrs Ratio of Government Total Transfers to Government Revenues pyrltax Payroll Tax Rate sstax Social Security Premium Paid by Formal Labor rtgtrhh Rate of Government Transfers to Households to Total Government Transfers rtgtree Rate of Government Transfers to Enterprises to Total Government Transfers FINANCIAL ACCOUNTS sP Marginal Propensity to Save rF Foreign Interest Rate on Public Debt rD Domestic Interest Rate on Public Debt ForBorE Enterprise foreign borrowing Gfborrat Government Foreign Borrowing Rate SECTORAL DEMANDS sP Marginal Propensity to Save clesi Sectoral Private Consumption Shares glesi Sectoral Government Consumption Shares iplesi Private Investment Demand Shares iglesi Government Investment Demand Shares | |||||||||||||||||||||||||||||||||||||||||||||||
= 
implies an equilibrium interest rate r for the economy. Thus the physical capital is mobile across sectors. It is the difference in sectoral profit rates that leads to the sectoral allocation of aggregate investments in within-period dynamics of the model. 
+ 
+ 
(27)
+
+
+ EtrHH + GtrHH + SSItrHH + eROWtrHH (32)
Domestic Price of 