How fiscal policies could help keep the 1.5-degree Paris goal alive

While many countries are now recovering from the COVID-19 crisis, others are still in the grip of the pandemic, and most find themselves debt-ridden and facing an uncertain future with new waves of infections, rising economic challenges, and mounting concern over how to tackle the impending climate crisis. Limited fiscal resources should therefore be used in the most efficient way possible to support a sustainable recovery. Fiscal policy has several tools to achieve these goals; carbon taxes, green incentives, and public green investment are the most notable. Which is most effective in supporting a recovery that is both fiscally and environmentally sustainable? 

Carbon taxes would work better if revenues were returned to the economy

In a recent working paper, Fiscal policies for a sustainable recovery and a green transformation, we argue that while carbon taxation may be the best instrument to encourage economic agents to produce and consume less emission-intensive goods, it is just one tool in the policy toolbox. Carbon taxation raises the price of energy, and tends to be contractionary and regressive, hence it is often politically very difficult to implement. The impact of carbon taxes may be less contractionary if the revenues are returned to the economy.  The model we used considers two scenarios regarding the use of carbon revenues. In the first scenario, the revenues are used to reduce labor income taxes. This results in an increase in households’ disposable income, which translates into higher consumption of all goods, and not just of low-carbon goods and services. In the second scenario, the carbon tax revenues are used to increase fiscal incentives for private green investments, which help to build up green energy capacity and foster the transition. However, even the green incentives are not sufficient to upgrade the supply of green energy fast enough to keep energy prices from increasing, which would delay the recovery and eventually lead to higher debt-to-GDP levels. 

What if each government invested an additional 1% of GDP?

Thus, even an environmental tax reform in which carbon revenues support green private investment may be insufficient to engineer a low-carbon transition. Scaling up public investment — particularly when interest rates are very low — is therefore essential not only to ensure a fast recovery from the crisis but to support a low-carbon transition. There is a clear argument in favor of government borrowing to invest for projects that pay off in the future, as the investment will benefit future generations. Debt-financed public investment increases the capital stock and accelerates growth, generating revenue that can be used to repay the debt incurred. Without debt financing, the present generation would be disproportionately burdened via higher taxes or expenditure cuts. However, this poses a challenge for fiscal policy. Would a debt-financed increase in public green investments provide sufficient stimulus to the green transition while at the same time preserving fiscal sustainability?

We present an illustrative scenario in which all governments in the world invest an additional 1 percent of GDP per year in green investment — financed with debt — for five consecutive years, while the revenues from carbon taxes continue to subsidize private green investments. This scenario delivers the most ambitious climate objective of containing global warming to 1.5 degrees by the end of the century. The additional public spending in green investments supports the low-carbon transition of the world economy. The debt-to-GDP ratio rises in the short term but declines afterward, reaching the lowest value — relative to the other scenarios — in the long term. Thus, the Paris objectives can be reached with a combination of three instruments: public investment, private investment, and carbon taxation.  

"Given that the major emitters are overwhelmingly represented by advanced and emerging economies with more financial capacity, shouldn’t these countries bear most of the costs of reducing emissions?"

Low-income countries would benefit from more advanced economies’ green public investment

Additional public green investment contributes to improved long-run fiscal sustainability in all countries even if it is financed with debt, because it limits the increase in temperature and climate-related damages.  But not all countries are equal. Who should pay for the transition to a green economy? Given that the major emitters are overwhelmingly represented by advanced and emerging economies with more financial capacity, shouldn’t these countries bear most of the costs of reducing emissions? Moreover, several low-income and vulnerable countries simply cannot afford to increase public green investment and may have more pressing needs competing for their scarce resources.  Therefore, we evaluated an alternative scenario, in which only advanced and emerging economies increase public investments. 

In this scenario, the larger spending on green public investment in advanced and emerging economies not only boosts global demand through positive trade spillovers into low-income and vulnerable countries but has the added benefit of mitigating temperature increases. The containment in global temperatures and climate disasters would open fiscal space in these countries for essential investments, such in health and education. 

This result is particularly important: It shows that carbon taxes, fiscal incentives for private investment, and an increase in public green investment — the latter only in the advanced and emerging and middle-income economies — would support the global recovery, ensure a higher growth path, and further contribute to keeping temperatures contained, which would especially benefit countries that are highly exposed to climate risks.