Can Carbon Taxes Be Effective?

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Arne Hoel/World BankIt was heartening to attend the recent Partnership for Market Readiness (PMR) forum at the World Bank, where countries renewed their commitments to testing and piloting market-based instruments for greenhouse gas emission reduction. The PMR is country-led and builds on countries’ own mitigation priorities. Focus is placed on improving a country's technical and institutional capacity for using market instruments to scale up climate change mitigation efforts.

The idea of using market-based instruments for pollution control dates back to 1920 when noted economist Arthur C. Pigou argued in his seminal work, “The Economics of Welfare,” that a tax should be applied to a market activity that generates negative externalities to correct the market outcome.

Over the years, pricing carbon or carbon taxes and carbon trading schemes have been accepted as potentially cost-effective means of reducing greenhouse gas emissions. From an economic perspective, carbon taxes are a type of Pigovian tax in that they help to address the problem that emitters of greenhouse gases not facing the full (social) costs of their actions.

While a number of countries have implemented carbon taxes or energy taxes and trading schemes that are related to carbon content, there has been a general lack of political appetite for embracing them wholeheartedly. The main opposition comes from the belief that in a country that imposes a carbon tax or similar energy input tax or trading regime, energy-intensive industries will suffer from a significant increase in production costs compared with their trading partners. It is feared that these industries will become less competitive internationally and lose their market share or, in order to avoid the loss, will migrate to countries with no such taxes.

In a paper titled, “The Effects of Domestic Climate Change Measures on International Competitiveness,” Hiau Looi Kee and I have tried to disprove this fallacy. We looked at all countries that had some form of carbon or energy tax and found that their overall economic competitiveness, and even the competitiveness of energy intensive sectors, was not compromised because of the tax. This is because most countries that have some form of a carbon tax today actively protect their most competitive sectors from the impact of the tax, either by exempting them or giving them generous allowances. Our study also does not give credence to the hypothesis that industries have been migrating en masse because of stringent carbon policies.

While it may be fair to say that a consensus is emerging in favor of carbon pricing or taxation, for carbon taxes to be effective as emission reduction tools, they should be:

  • Imposed purely with the objective of targeted emission reduction, rather than with a view to protect the competitive industries or sectors;
  • Uniformly applied across all industries;
  • Designed to mitigate any adverse impacts on the poor; and
  • Complemented with adequate border provisions to avoid any “carbon” leakage.


Muthukumara Mani

Lead Environmental and Climate Change Economist

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