Effects of a CO2 Tax

WIFO Working Paper by Angela Köppl and Margit Schratzenstaller Provides Literature Review
WIFO researchers Angela Köppl and Margit Schratzenstaller contributed to a study on behalf of the European Commission with a detailed overview of the theoretical and empirical literature on the main effects of CO2 taxes. This review has now been published in a WIFO Working Paper.

In view of the challenges posed by climate change and the increase in climate targets by 2030 in the EU, as well as Austria's goal of achieving climate neutrality by 2040, the question of effective climate policy instruments is gaining in importance.

The pricing of CO2, for example in the form of a CO2 tax, and the question of its effects is therefore attracting increasing attention in academic as well as economic and environmental policy discussions. This is the background of a recently published study coordinated by the economic research institute Ecorys on behalf of the European Commission on the status of CO2 taxation in the EU member countries.

Environmental taxes need to be considered in a broader perspective in the context of climate change, and it is important to keep in mind that the transition to climate neutrality requires a profound structural change that cannot be achieved through incremental (political) steps. Rather, such a deep structural change implies an enormous investment requirement. In this context, the focus needs to be on a broader policy mix that integrates a wide range of instruments such as price-based instruments, subsidies, standards and public infrastructure investments. Several studies suggest that a strategic combination of climate change measures can yield significant synergies. Environmental taxes therefore need to be integrated into a broader system perspective. Moreover, given the urgency of greenhouse gas emission reductions, the transformative signal of policy instruments toward long-term decarbonisation is of paramount importance.

Several conclusions can be drawn from the extensive review of the theoretical literature on the impact and significance of environmental taxes in general and CO2 taxes in particular. These relate to the main impact dimensions of CO2 taxes: environmental effectiveness, effects on important macroeconomic variables (especially growth and employment), effects regarding innovation and competitiveness, distributional effects, and public acceptance.

First, while environmental taxes are an important tool in a toolbox of available environmental policy instruments, they are insufficient as a stand-alone measure for several reasons. Nevertheless, the pricing of negative externalities has long been one of the central pillars of environmental economics. Yet "optimal" pricing in the context of climate change faces uncertainties related to the complexity of the climate system. The specifics of climate change require a broadening of the perspective on CO2 taxes due to the importance of stock-flow relationships or market barriers such as the principal-agent problem between homeowners and renters. Crucial to CO2 pricing is the specific design of the policy, especially with respect to distributional effects, which significantly affect public acceptance.

A review of the empirical studies allows several conclusions with respect to the various impact dimensions considered. An increasing number of ex-post studies – both country studies and cross-country analyses – show that CO2 taxes can effectively reduce CO2 emissions or at least dampen their growth without affecting economic growth and employment. The estimates of emission-reducing effects identified in the available ex post evaluations fall within a fairly broad range and are often rather moderate. The level of the CO2 tax rate is a crucial factor for its effectiveness: only an appropriately high tax rate is able to effectively reduce CO2 emissions. The key to achieving a double dividend, consisting of environmental effectiveness and an economic benefit, is the use of carbon tax revenues: recycling revenues via reductions in social security contributions and taxes on labour income is usually associated with a double dividend, in contrast to lump-sum transfers. Moreover, CO2 taxes have little, if any, impact on the competitiveness of firms. To date, however, there is a lack of convincing empirical evidence that putting a price on CO2, e.g., via CO2 taxes, can bring about the technological change needed to fully decarbonise the economy and society. There is also empirical consensus that environmental taxes have differentiated distributional effects: in general, taxes on fuels have a progressive effect in many countries, while taxes on heating fuels are slightly regressive and taxes on electricity are significantly regressive. Model simulations show that lump-sum transfers are better suited to mitigate the regressive effects for lower incomes, while higher incomes benefit more from a reduction in taxes on labour. Climate change investments from tax revenue resources play a role in public acceptance. Public acceptance of carbon taxes depends on a number of factors and can be increased by providing public information, avoiding negative distributional effects, and earmarking part of the revenues for "environmental projects". "Package solutions" combining several climate policy measures in general and price-based instruments in particular can be more effective than single measures.

Finally, apart from the broad theoretical and empirical consensus on the usefulness of environmental taxes, any specific policy reform must take into account both the system boundaries and the specific political context and general socio-economic conditions and policy styles in the country concerned. Moreover, the relevant literature suggests that international or at least EU-wide policy coordination brings additional economic and environmental benefits.