45120 The World Bank JULY PREMnotes 2008 NUMBER 2 SPECIAL SERIES ON THE ECONOMICS OF CLIMATE CHANGE What is the role of carbon taxes REVISED APRIL 2010 in climate change mitigation? Joseph Aldy, Eduardo Ley, and Ian Parry This note argues that a carbon tax system is more practical to implement, monitor and enforce than tradable permit-based approaches to global climate-change action. It suggests that a sensible design would be an upstream carbon tax on the fossil fuel supply chain, which could also include other major non-CO2 greenhouse gases (GHGs). While risks such as fiscal cushioning exist, a tax-based system would be more transparent and offer the appropriate incentives for participation and compliance. “I prefer carbon and/or gasoline tax measures to However, there is a potentially strong permit systems or heavy regulatory approaches case for carbon taxes, if revenues are used because the latter are more likely to be economically productively. Moreover, even if CO2 taxes inefficient and to be regressive.” —Lawrence are not implemented in the near term, it Summers, former U.S. Treasury Secretary, is important to assess the possible case for currently Professor at Harvard University transitioning to a tax-based system over the longer haul. Thus, it is important to under- “Frankly, a Kyoto-type framework—one with stand how CO2 taxes might be designed at a global quantitative emissions targets allocated domestic and international level, and their among countries […] is not feasible. The only ap- advantages and disadvantages compared proach that will fulfill the conditions and relieve with permit-based approaches. countries’ apprehensions regarding sovereignty The choice among alternative control and free riding is one in which all countries agree instruments for CO2 emissions is inherently to penalize their carbon emissions in such a way difficult as it involves multiple criteria of con- that, over time, an internationally harmonized car- cern to policymakers. These criteria include bon price prevails. If you’re worried about climate economic efficiency—i.e., maximizing envi- change but don’t like carbon taxes, think about the ronmental benefits less mitigation costs—or messy or even impossible alternatives!” —Ernesto more broadly, cost-effectiveness—that is, Zedillo, former president of Mexico, cur- minimizing the costs of achieving near- and rently Director of the Center for the Study long-term goals for emissions reductions. of Globalization at Yale University Other criteria include minimizing the risks of excessive abatement, or of excessive emis- The alternative instruments most favored sions releases, in presence of uncertainty over by economists for controlling emissions of abatement costs. A further criterion is that of GHGs are CO2 taxes and systems of tradable incidence: the distribution of costs borne by CO2 permits. Most of the policy discussion different household income groups, and by in- has focused on cap-and-trade systems, given dustries, especially those with political clout. that this policy was embodied in the Euro- The Discussion Paper accompanying pean Union’s Emissions Trading Scheme this PREM Note discusses in detail how well (ETS), and it is also the centerpiece of most carbon tax and cap-and-trade systems are climate bills currently pending in the U.S. likely to perform according to these criteria. Congress. One especially prominent result is that when FROM THE POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK there is large uncertainty about the costs sponding tax credits for sequestration. This of emissions abatement, then carbon taxes tax, which would be levied in proportion to a could be significantly less costly that cap-and- fuel’s carbon content, would be largely passed trade systems. Nevertheless, whether or not forward into the price of coal, natural gas, there is a strong case for preferring taxes to and petroleum products, and therefore ulti- cap-and-trade systems hinges critically on mately embodied into the price of electricity how those policies are actually designed. If and other energy-intensive products. Incor- cap-and-trade programs incorporate provi- porating at least some non-CO2 greenhouse sions to contain permit price volatility, and to gases into the tax system is quite feasible, as is transition to full allowance auctions as rapidly providing incentives for downstream geologi- as politically feasible, with judicious use of the cal and biological CO2 sequestration. resulting government revenues, there would The most critical issue is deciding the tax not be a strong case for overhauling such level. Standard welfare-maximizing theory systems in favor of an emissions tax. However recommends that the appropriate CO2 tax if, for whatever reasons, the only viable type should reflect marginal damages, or the of permit system is of the pure form, without discounted value of worldwide damages from these provisions, (revenue-neutral) CO2 taxes the future global warming caused by an addi- seem a better alternative. tional ton of CO2 emissions. These damages include, for example agricultural impacts, the costs of rising sea levels and increased Domestic Carbon Taxes storm intensity, health effects, ecological Besides the basic choice between emissions disruptions, the risks of major disruptions taxes and cap-and-trade systems, and how to world output from more extreme climate government revenues might be used to meet scenarios, and so on. Predicting and valuing a variety of competing criteria of concern to these impacts is extremely difficult and con- policymakers, there is wide range of further troversial. Mainstream estimates, using mar- practical issues in the design of a domestic ket discount rates, put the damage per ton of CO2 mitigation policy. Most fundamental carbon at around $30 or more—equivalently, is the emissions price (or level of emissions upwards of $8 per ton of CO2. control under a permit system), and how it An alternative approach is to assess near- should be adjusted over time. In addition, term emissions prices that are consistent there are issues related to the point of regula- with ultimately stabilizing expected global tion, what if anything can be done to deter warming at “acceptable” levels. A (global) emissions leakage through outsourcing, how price of $10 per ton of CO2 in the near term to incorporate non-CO2 greenhouse gases is broadly consistent with an emissions price and downstream sequestration activities, and path to ultimately limit expected warming to to what extent emissions control policies should 3oC above current temperatures. But if the be complemented with additional instruments goal is to limit expected warming to 2oC, a to promote emissions-saving technologies. much more aggressive policy is required, At a domestic level, designing a CO2 tax pricing near-term CO2 emissions in the order is fairly straightforward, especially if imposed of $25 to $70 per ton. upstream in the fossil fuel supply chain. In Choosing how to use carbon tax rev- principle, the marginal costs of emissions enues is also critically important. There are reductions across all options will be equated potentially large gains in economic efficiency when all firms and households face prices from using them to lower the rates of other for fuels and energy-intensive products that distortionary taxes, like income taxes. And reflect the costs of the embodied carbon, recycling can be tilted towards lower income while receiving credits for any offsetting groups to partly address the distributional downstream sequestration activities. These consequences of higher energy taxes. Al- cost-minimizing conditions could be largely lowing some infra-marginal emissions to be achieved under a CO2 tax applied upstream exempt from the tax for a period may also in the fossil fuel supply chain, with corre- help with political feasibility. 2 PREMNOTE JULY 2008 International Taxes The potential for rent extraction by Reaching international agreement over a the OPEC cartel is greater when facing a quantity-based approach to emissions con- cap set by energy-importing countries than trol is potentially difficult and contentious. when facing an importer carbon tax. The In a Kyoto-like system, countries have to cap could become an effective coordination agree on a set of national emissions targets. mechanism. Relatedly, for a carbon tax, the Initially, these targets can be set relative to upstream principle could be interpreted to actual emissions in a recent ‘reference’ year; suggest that the tax ought to be levied at the this reference was chosen to be 1990 in the fossil fuel source—i.e., levied on oil produc- Kyoto Protocol. However, a problem is that, ers. However, as with a VAT, exports could moving forward, baseline emissions—i.e., obtain credits for taxes paid and carbon taxes emissions that would have occurred in the would be then levied on the carbon content absence of a CO2 control policy—may grow of imports by the importing country. at very different rates in different countries An alternative approach would be to leading to difficulties in updating country monitor each country’s emissions, in addition emissions quotas over time. to their formal CO2 tax. Countries might be In contrast, under a tax-based regime required to satisfy an, albeit relatively slack, there is only variable to negotiate over—the target for emissions, which puts a floor un- tax rate on CO2 that every country should der the emissions reductions. Exemptions to impose, along with a rule for adjusting it over meeting the floor might be granted only in time. This avoids the haggling over country- the event that a country can credibly dem- level targets that is inherent in a Kyoto-style onstrate exceptional circumstances—e.g., approach. unexpectedly rapid productivity growth. One concern about a system of inter- national emissions taxes is that it could be International Climate undermined by ‘fiscal cushioning,’ that is, the reduction of other taxes borne by sources of Policy Architecture greenhouse gas emissions to offset the bur- Pursuing a purely efficient and cost-effective den of a CO2 tax. For example, when Sweden carbon tax policy may not necessarily be the introduced its CO2 tax in 1991, it cut energy most equitable approach to international taxes by 50 percent. In some cases, offsetting climate policy. The extra stock of carbon reductions in other energy taxes are transpar- in the atmosphere that may be responsible ent (e.g., a reduction in gasoline tax), but for anthropogenic climate change is the not in others (e.g., complex tax loopholes counterpart to past economic development for expensing of capital or technology in- activities of today’s richer nations. In this vestments). One possible response to this context, imposing the same carbon tax rate problem is to develop a broader measure of on the consumption of energy in countries a country’s CO2, taking account of pre-exist- substantial differences in per capita incomes ing energy taxes or subsidies. For example, may be viewed as regressive and unfair. the $0.40 per gallon tax on gasoline in the The equitable approach to emission U.S. would amount to a pre-existing tax of targets in the Kyoto Protocol suggests a $9 per ton of CO2, given that a gallon of fairly progressive assignment of stringency gasoline produces 0.009 tons of CO2 and by incomes among industrialized countries. A gasoline accounts for one-fifth of nationwide carbon tax, by design, does not create endow- CO2 emissions. Similarly, estimated revenues ments (like emission permits) that can be al- forgone to the government from the favor- located to lower-income countries as a means able tax treatment of energy industries could of compensation. At the risk of undermining be expressed per ton of CO2. In principle, all cost-effectiveness in the near term, a system countries might be required to increase this of graduation could be employed in which broader CO2 tax at the same rate over time. only countries that have cleared a specified Therefore, any reductions in other energy income threshold would be expected to taxes would need to be offset by a higher implement a carbon tax. formal tax on CO2. JULY 2008 PREMNOTE 3 Alternatively, direct side payments from is a sufficient measure of the comparability of wealthier nations to poorer ones could easily effort across countries. Countries may imple- be made, based on an agreed formula that ment complementary policies—such as fuel takes into account per capita income and economy standards, renewable portfolio stan- historical emissions. This would help to build dards, biofuel mandates, etc.—that result in broader support for a carbon tax approach additional emissions abatement (and abate- to international climate policy. Some funds ment costs) than under a tax-only approach. could support technology transfer to devel- Such evaluations may also be valuable in oping countries or various adaptation efforts cases when some countries only tax a subset and promote better institutional capacity in of their greenhouse gas emission sources. developing countries to cope and adjust to changing climate and sea levels. This brief draws from J. E. Aldy, E. Ley, and A carbon tax could provide for some I. Parry, (2008), “A Tax-Based Approach to Slow- appropriate incentives for participation ing Global Climate Change,” PREM Economics and compliance. First, the cost of this policy of Climate Change Discussion Papers. instrument is much more transparent than a quantitative emission target. Second, the withdrawal of a country from a global About the authors Joseph E. Aldy is a Fellow at Resources for harmonized carbon tax does not risk the the Future, Co-Director of the Harvard Project contagion that could occur via international on International Climate Agreements, and the permit markets under a system of quantita- Co-Director of the International Energy Workshop. tive targets. Third, a domestic carbon tax Eduardo Ley is a Lead Economist with the Eco- policy might make it simpler to employ a nomic Policy and Debt Department of the PREM border tax adjustment consistent with the Vice Presidency. Ian Parry is Allen Kneese Chair World Trade Organization on imports from and Senior Fellow at Resources for the Future, a countries failing to impose carbon taxes than Washington DC–based research foundation spe- under a cap-and-trade based policy. Fourth, cializing in environmental and energy policy. reliance on the revenue streams will promote the establishment of domestic constituencies in support of maintaining carbon taxes. About the note series These issues suggest several policy ele- The PREM note series on the Economics of Cli- ments necessary in implementing a global mate Change is part of the effort conducted by the carbon tax. First, systematic and regular Poverty Reduction and Economic Management reviews of countries’ carbon tax policies Vice Presidency of the World Bank to raise aware- are necessary. These reviews would assess ness on poverty, distributional, financial, fiscal, whether governments undertake explicit (by and trade related issues that tend to be underesti- changing other tax laws) or implicit (by fore- mated in the more scientific and political debates going revenue collection) fiscal cushioning surrounding Climate Change. The notes do not for various sources subject to the carbon tax necessarily reflect the view of the World Bank, its policy. Second, a review of the aggregate ef- board or its member countries. However, they do fect of carbon tax policies can inform consid- reflect the content of some of the internal debates eration of whether this approach adequately among economists interacting traditionally on mitigates the risks posed by climate change. emerging or overlooked economic consequences of Such a review can guide negotiations about environmental policies. the level of carbon taxes. Third, these evalua- For questions, please contact Milan Brahmbhatt tions should determine whether the tax level at mbrahmbhatt@worldbank.org. This note series is intended to summarize good practices and key policy findings on PREM-related topics. The views expressed in the notes are those of the authors and do not necessarily reflect those of the World Bank. PREMnotes are widely distributed to Bank staff and are also available on the PREM Web site (http://www.worldbank.org/prem). If you are interested in writing a PREMnote, e-mail your idea to Madjiguene Seck at mseck@worldbank.org. 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