Nova workboard

a blog from young economists at Nova SBE

Carbon Pricing and Climate Change: An Economically Efficient Solution?

The U.S. government recently made headlines for declining to sign a World Bank declaration supporting a global price on carbon, a decision that stems from an ongoing political debate over the costs and benefits of using economic instruments to combat climate change. Republicans, many of whom represent states and districts that still rely heavily on coal production, generally argue against pricing carbon emissions. Their argument stems from the concept that any tax on a good distorts the market, shifting it away from the equilibrium point where consumers maximize their utility at the market price and firms maximize their profits. Since energy is a key factor in production, they also argue that raising the price of energy in the U.S. relative to countries that don’t impose a tax will reduce the competitiveness of American firms on the global market and drive many of them out of business.

Democratic supporters of a carbon tax, on the other hand, contend that it would improve general economic well-being by shifting the cost of externalities onto the emitters. They also assert that a carbon tax will favorably change the behavior of producers and consumers by encouraging the use and development of renewable alternatives to fossil fuels.

A recent IMF working paper and a report by The Global Commission on the Economy and Climate propose that countries can actually reap net economic benefits from reducing emissions, providing a potential point for compromise. The IMF report focuses on carbon taxes, claiming that a carbon tax can be an economically efficient solution if governments use the revenue to reduce income taxes. In contrast to the simple model we have studied in class, the report analyzes these tax changes in respect to an economy that is already shifted away from equilibrium by a complex system of distortion-inducing taxes, and asks whether the policies under consideration will bring the economy closer to or further from general equilibrium.

This type of policy change falls into the category of Hicksian compensated demand, a price change where consumers are otherwise compensated to bring their income to the minimum level that allows them to obtain the same utility as their previous consumption choice. Such a policy achieves the intended behavioral change by shifting consumption away from energy, whose price goes up, while ensuring that consumers can still choose a consumption bundle that gives them the same level of utility.

The real-life effects of policy change are not quite as clear as in the simplified world of theory. In a large and complex global economy, it’s much more difficult to predict whether a carbon tax will result in a net economic cost or benefit, or what will be the impact on equity. Politicians in the U.S. have used economic arguments to advocate both for and against the implementation of carbon taxation, resulting for now in hesitation from the federal government in implementing policy change.


Author: studentnovasbe

Master student in Nova Sbe

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