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date: 03 March 2021

Carbon Taxation and the Paris Agreementlocked

  • Ian ParryIan ParryFiscal Affairs Department, International Monetary Fund

Summary

The window of opportunity for containing risks of dangerous instability in the global climate system is closing rapidly. The response of the international community is embedded in the 2015 Paris Agreement, signed by 195 parties. Implementing the mitigation pledges parties submitted for the agreement is an important first step, although an additional mechanism to coordinate and scale up mitigation policy at the international level will likely be needed. Carbon taxation, or similar pricing, has a pivotal role, providing across-the-board incentives for reducing emissions and the critical price signal for redirecting investment, but pricing has proved difficult politically. Analytical literature on carbon taxation provides practical guidance on the role of taxation in implementing the Paris Agreement and enhancing its acceptability.

Shifting taxes off labor and capital and onto carbon or fossil fuels can produce a “double dividend” by reducing environmental harm and lowering the burden broader taxes impose on the economy. Broader taxes both discourage work effort and investment and promote tax-sheltering behavior (e.g., activity in the informal sector). For various technical and practical reasons, however, it may not make sense to set the carbon tax rate above levels warranted on environmental grounds.

The literature emphasizes the general importance of using carbon pricing revenues to benefit the economy, for example, lowering burdensome taxes or funding productive investments. These economic benefits are forgone if instead carbon pricing revenues are given to households in lump-sum dividends. Where higher energy prices are subject to public acceptability constraints, a package of regulations or their fiscal equivalents (known as “feebates”) have an important role in reinforcing carbon pricing. Carbon mitigation can also produce important domestic environmental co-benefits, such as reductions in local air pollution mortality. Unilateral action may be in many countries’ own interests before even counting the global climate benefits.

Recent studies have quantified the carbon prices implicit in countries’ Paris mitigation pledges. These implicit prices differ widely across countries with the stringency of pledges and the responsiveness of emissions to pricing, underscoring the potential efficiency gains from some degree of price coordination at the international level. In fact, an international carbon price floor arrangement could be strikingly effective to the extent that it promotes more mitigation in key emerging market economies, such as China and India. The price floor need only cover a handful of large emitters, could be designed equitably with higher requirements for advanced countries, and could be designed flexibly to accommodate different policy approaches at the national level.

Domestically, policymakers need to develop comprehensive mitigation strategies, ideally with carbon pricing as the key element. These strategies need to distribute burdens equitably, assist vulnerable groups, and include supporting measures for investment and pricing for broader sources of greenhouse gases.

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