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Editor’s Note: S&S is collaborating with the Harvard Environmental Economics Program (HEEP) to bring academic research findings to a broader audience. Writers at S&S are producing short summaries of discussion papers from HEEP and the Harvard Project on Climate Agreements (HPCA), streamlined for policymakers. As these summaries are published, they will be adapted and discussed here.

It is difficult for finance ministers to raise revenue by taxing a firm’s mobile capital assets because the costs of relocating that capital in response to tax pressure have been reduced by globalization. Countries compete for this capital by reducing their capital tax rates. Governments are still pressured to provide welfare-enhancing public infrastructure investments despite this reduction in revenue.

Carbon taxes are a way to raise revenue without chasing firms abroad because carbon assets are not mobile or evenly distributed geographically. A tax on carbon imports cannot be avoided by relocation as easily as a tax on mobile capital. As a result, finance ministers who may not otherwise care about the environment may favor a carbon tax as a way to finance welfare improving public investment.

In a globalized world, capital is highly mobile. Taxing this capital causes firms to relocate to countries with low tax rates, which reduces government revenue and local employment. To entice firms to stay, governments have reduced corporate tax rates and increased payroll taxes that fall on relatively immobile labor. Unlike capital or labor, carbon intensive resources (fossil fuels) are found unevenly around the world. This geographic advantage means exporters of fossil fuels are able to charge a higher price because they have less competition. Income produced by this advantage is called “rent.”

The authors of a new study hypothesize that taxing carbon allows an importing government to raise revenue to finance public infrastructure investment without increasing taxes on individuals or businesses, thereby decreasing domestic output. Increasing investment in infrastructure is welfare-enhancing as long as the financing for the investment is generated in a way that does not decrease output. A tax levied on carbon generates revenue by distributing a portion of fossil fuel rents to the importing country without generating a race to the bottom in tax rates or inciting firms to relocate.

The authors construct a multi-period, multi-country general equilibrium model to test these hypotheses. The model includes two groups of countries: those that import carbon intensive resources and those that export carbon intensive resources. Importing countries are able to set taxes on imported carbon resources, domestic labor, and domestic capital. Exporting countries can choose to set a tax on exported carbon resources. Within the importing countries, firms can respond to taxes strategically (i.e. by relocating production). Consumers derive welfare from the wages they receive from firms, improvement in public infrastructure, and dividend payments they receive as owners of the firms. Governments use taxes to provide public infrastructure and choose tax rates to maximize consumer welfare.

The model assumes that importing countries resemble the OECD countries (like the United States) while exporting countries resemble the developing world.

Key Findings & Recommendations

  1. A carbon tax increases consumption by several trillion dollars. Compared to the scenarios in which importing countries use only taxes on consumption, capital, or payroll to finance infrastructure investment, using only the optimal carbon tax increases the present value of consumption by $21 trillion USD.
  2. Welfare declines with the use of non-carbon taxes relative to carbon taxes. Comparing the welfare under the non-carbon tax regime to the carbon tax regime shows that carbon taxes increase welfare by 2.3% relative to the next best option.
  3. Carbon taxes shift rents from exporting to importing countries. The exporting country’s profits are affected by all of the tax regimes. However, the carbon tax reduces these profits by the largest amount (profits are 36% lower than the next best option). This is an indication of a transfer of the rents from the exporting to the importing country under the carbon tax.
  4. These results are robust to strategic interactions between firms and countries. The model allows for exporting countries to react strategically to the implementation of a carbon tax by importing countries. However, the benefits of a carbon tax, relative to a capital tax, remain even as the exporting country reacts strategically.
  5. Implementation of the carbon tax slows resource extraction and decreases total volume extracted. By implementing a tax on the carbon intensive resource, the importing countries increase the price paid by consumers and decrease the price received by producers. This reduces demand, generates conservation of the resource, and results in environmental benefits. All of these benefits occur despite the initial impetus for the carbon tax – raising revenue for infrastructure improvements.

Taxing carbon intensive fossil fuels allows finance ministers to generate revenue to finance investment in public infrastructure without taxing mobile capital. This allows countries to invest in welfare enhancing public infrastructure without causing capital flight and negatively impacting growth by driving firms overseas. As a result, a carbon tax improves welfare in countries that import fossil fuels on a financial level in addition to an environmental level. Despite not being motivated by environmental protection, a carbon tax slows production, reduces consumption, and benefits the environment.

Image courtesy of Wikimedia Commons. Originally published by S&S on October 7th, 2015. 


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