Climate change mitigation policy in a non-cooperative world

Abstract

In climate change mitigation policy, carbon taxation is seen as an effective and efficient policy instrument. However, some caveats like carbon leakage may hamper its performance. This thesis presents an assessment of various alternative market-based climate policy instruments: A residence-based tax on capital income, a source-based tax on capital input in production, and cap-and-trade policy. For the latter, two regimes are analyzed: local and global permit markets. An essential aspect, which connects all chapters, is that the assumption that countries do not cooperate but set their policies in a strategic, non-cooperative manner. The resulting inefficiencies are identified for all the above listed instruments. In Chapter 2, we analyze a multi-country, 2-period, Nash tax competition game to evaluate Sinn’s proposal to use interest income taxation as a means to decelerate fossil fuel extraction (Sinn, 2008, p. 384). The interest rate is determined on a perfectly competitive consumer loan market on which the resource extractor acts as the loan supplier. Households, which constitute the demand side, pay a local capital income tax on their loan. We find that this tax is effective in back loading extraction to the future, which limits damage from climate change. Yet, equilibrium tax rates are inefficiently low, given countries are symmetric. Inefficiency is due to presence of two externalities the intertemporal fiscal distortion and the environmental externality. The second result is that, in an asymmetric setting with resource-exporting and -importing countries, cooperation among the latter leads to welfare gains for these compared to the Nash equilibrium. Furthermore, we find that given the cooperation among resource-importing countries, there are cases where the resource-exporting country has an incentive to join the policy cooperation so that full cooperation is self-enforcing. Chapter 3 assesses the 2-period, non-cooperative equilibrium of an n country policy game where countries chose either (i) carbon taxes, (ii) cap-and-trade policy with local permit markets or (iii) cap-and-trade policy with internationally linked permit markets and potential central redistribution of permit revenues. Policy makers maximizes welfare, which depends on household consumption over time and environmental damage from period-1 resource use. We assume costless and complete extraction of this non-renewable resource, so damage only depends on speed of extraction. Tax policy is the least efficient option due to carbon leakage, which introduces a second externality adding to the environmental externality. Cap-and-trade policy does not show any leakage since all symmetric countries will employ caps. Its equilibrium thus only suffers from the environmental externality and welfare is higher than under carbon taxation. The policy scenario with linked permit markets and central redistribution yields an efficient iii outcome. The redistribution of revenues creates a negative externality which offsets the positive environmental externality. Chapter 4 analyses and compares the performance of carbon taxes and capital taxes in financing public goods while considering positive effects of public expenditure on firm productivity. It is motivated by Franks et al. (2017), who ask whether using carbon taxes could be motivated on fiscal rather than by environmental grounds, arguing that the advantage of the carbon tax consists in its potential to reap foreign resource rents. I employ an analytical general equilibrium framework of n identical countries, where local firms use internationally mobile capital and imported fossil fuel in production as well as local public infrastructure. The latter is financed solely by either taxing the input of fossil fuels or capital. The choice of the policy instrument is exogenous to policy makers and symmetric across countries. I find that the effect of policy on the fossil fuel price (terms-of-trade effect) leads to higher public good provision under carbon taxation. However, tax-competition could cause either policy instrument to yield higher provision depending on how strongly either tax base reacts to changes in the tax rate. Therefore, the ranking of the two policy scenarios is ambiguous when considering tax competition and the terms-of-trade effect simultaneously. A numerical exercise shows cases for higher provision of either policy.