Is a Uniform Carbon Tax a Good Idea? The Case of Switzerland

Transcription

1 Is a Unform Carbon Tax a Good Idea? The Case of Swtzerland By Floran Lands, Sebastan Rausch, and Mrjam Kosch Ths paper analyzes the mplcatons of dfferentated carbon taxes for the economc costs of decarbonzaton, usng Swss clmate polcy as an example. Employng a numercal general equlbrum model wth multple fuels, end-use sectors, and heterogeneous households, we assess the emprcal relevance of three motves for carbon prce dfferentaton: fscal nteractons wth the exstng tax code, transportaton externaltes, and concerns about dstrbutonal equty. We fnd that cost-effectve clmate polcy entals substantally lower taxes on motor than on thermal fuels (by a factor of ) and that unform carbon prcng forgoes szeable effcency gans (between 5 41 percent). The case for carbon tax dfferentaton s robust but somewhat weakened f emssons reducton targets are ambtous or f non-clmate transportaton externaltes are taken nto account. A fundamental tenet of envronmental economcs concernng the regulaton of a unformly dspersed pollutant such a carbon doxde (CO 2 ) s that the cost of achevng a gven emssons reducton s mnmzed f margnal abatement costs are equalzed across all emtters. Market-based nstruments lke emsson taxes (Montgomery, 1972; Baumol and Oates, 1988) or a system of tradable emsson permts (Dales, 1968; Montgomery, 1972) operatonalze ths dea by establshng a unform prce on emssons across all sources. Whle polcy advsors have been embracng ths smple rule, several reasons for devatng from unform carbon prce exst. Theoretcal arguments nclude tax nteracton wth pre-exstng taxes, externaltes unrelated to CO 2 emssons, nternatonal spllover effects (Markusen, 1975; Hoel, 1996), or market power of large open economes (Krutlla, 1991; Rauscher, 1994). The complexty of analytcal expressons that descrbe second-best prcng rules and effcency costs means, however, that no clear results about the magntude of overall effects can be obtaned. The ambguty predcted by Lpsey and Lancaster (1956) s general theory of the second best, suggests that the answer to We gratefully acknowledge fnancal support by the Swss Competence Center for Energy Research, Competence Center for Research n Energy, Socety and Transton (SCCER-CREST) and the Commsson for Technology and Innovaton (CTI). We thank Renger van Neuwkoop for hs support wth data preparaton. We would lke to thank Jan Abrell for helpful comments. Correspondng author: Sebastan Rausch, Department of Management, Technology and Economcs, Swss Federal Insttute of Technology (ETH) Zurch, Swtzerland, Center for Economc Research at ETH (CER-ETH), and Massachusetts Insttute of Technology, Jont Program on the Scence and Polcy of Global Change, Cambrdge, USA (emal: srausch@ethz.ch). Lands: Department of Management, Technology and Economcs, Swss Federal Insttute of Technology (ETH) Zurch, Swtzerland. Kosch: Department of Management, Technology and Economcs, Swss Federal Insttute of Technology (ETH) Zurch, Swtzerland. 1

2 2 such questons strongly depends on the specfc context,.e. the type of externaltes and dstortons n a specfc economy and envronmental polcy context. Our analyss uses the example of clmate polcy n Swtzerland to provde an emprcal context n whch the effects of dfferentated carbon prcng can be llustrated. A common feature of current and past Swss carbon tax polcy proposals (Federal Councl, 2015a,b; Imhof, 2012) s to dfferentate carbon prces by fuel type such that motor fuels are taxed at a much smaller rate as compared to fuels used for non-transportaton purposes. The tax nteracton wth preexstng taxes on motor fuels has been dentfed as a reason for carbon prce dfferentaton before (n the Swss context by Imhof (2012), 1 n the European context by Paltsev et al. (2005b); Abrell (2010)). We elaborate on these prevous efforts by systematcally lookng for the optmal level of carbon prce dfferentaton between motor and thermal fuels. Wth regard to the poltcal process, we do not want to provde arguments for new dmensons along whch to dfferentate carbon prces arguments, whch could be hgh-jacked by lobby groups (Boeters, 2014). We nstead provde an analyss of exstng proposals for carbon prce dfferentaton and gve advce on how to mprove them from an economc perspectve. We further consder how the economc ratonale for carbon prce dfferentaton s altered by the presence of other externaltes that are not related to CO 2 emssons. We also nvestgate to what extent carbon prce dfferentaton may nvolve a trade-off between effcency and equty, focusng on mpacts among household groups wth dfferent ncome. Expendture shares for heatng and electrcty tend to be hgher for poorer as compared to rcher households, n turn leadng to a regressve ncdence of rsng prces on the uses sde (Metcalf, 1999; Rausch, Metcalf and Relly, 2011; Fullerton, Heutel and Metcalf, 2012). For taxes on motor fuels, on the other hand, we would not predct ths regressvty n many OECD countres (Sterner, 2012). Hence, whle dfferentatng carbon prces between fuels may enhance effcency, t may amplfy unntended dstrbutonal outcomes. To derve our results, we develop a comparatve-statc mult-sector small open economy numercal general equlbrum model for Swtzerland. The model features a detaled representaton of energy supply and converson actvtes comprsng varous fuels and secondary energy supply. Household heterogenety s captured by dfferentatng spendng and ncome patterns of 14 representatve household groups based on ncome and work status (retred vs. workng age). To capture the major tax dstortons n the Swss economy, the model ncludes payroll taxes, prvate ncome taxes, value-added taxes, mport tarffs by commodty, sector-specfc output taxes and subsdes, and energy-related taxes ncludng mneral ol taxes. Our analyss provdes clear support n favour of carbon tax dfferentaton. Costeffectve clmate polcy, n the Swss context, entals substantally lower taxes on 1 Other recent studes of Swss clmate polcy nclude Bretschger, Ramer and Schwark (2011); Scea, Thalmann and Velle (2009); Scea et al. (2012), whch do not explctly consder dfferentated carbon prces. Scea, Thalmann and Velle (2009); Scea et al. (2012) analyze transportaton-specfc emsson reducton targets and fnd them to be an neffcent devaton from unform carbon prcng.

3 motor fuels than on thermal fuels (by a factor of ). We fnd that unform carbon prcng forgoes szeable effcency gans on the order of 5 41% relatve to optmally dfferentated carbon taxes, dependng on the strngency of clmate polcy. The man drver behnd ths result s a tax nteracton effect that creates addtonal effcency losses due to a double taxaton of transport fuels through mneral ol and carbon taxes. The case for carbon tax dfferentaton remans robust but s somewhat weakened f emssons reducton targets are large or f non-clmate transportaton externaltes are taken nto account. If we assume that the mneral ol tax on motor fuels s prcng an externalty, we fnd that CO 2 taxes should be dfferentated much less and that a unform carbon tax s closer to the optmum than a dfferentated tax structure as s proposed by Swss clmate polcy. We do not fnd evdence for an effcency equty trade-off as far as the dfferentaton between carbon taxes on motor and thermal fuels s concerned. A carbon tax on transport fuels s cost-neffectve compared to a carbon tax on thermal fuels and leads to a more dspersed dstrbutonal outcome. Carbon prcng polces that are only based on taxng transport fuels are hence also undesrable from the vewpont of dstrbutonal equty. For the analyzed carbon prcng schemes, dstrbutonal mpacts by household ncome group are domnated by the progressve effects from carbon revenue recyclng. A small but growng lterature has been usng quanttatve methods based on numercal general equlbrum models to nvestgate the effcency mpacts from carbon prce dfferentaton. As expected, these analyses reveal that there s consderable case-to-case varaton of conclusons that are drawn. Comparng gven schemes for dfferentatng carbon prces, Böhrnger and Rutherford (1997), Babker et al. (2000), and Kallbekken (2005) fnd that dfferentatng the tax rate on a fossl energy carrer across sectors entals effcency costs rather than benefts. Böhrnger, Lange and Rutherford (2014) ask to what extent carbon leakage provdes an effcency argument for dfferentated emsson prces n favor of emsson-ntensve and trade-exposed sectors under unlateral clmate polcy. They fnd that both the leakage and terms-of-trade motves yeld only small effcency gans compared to unform emsson prcng and thus conclude that n many cases the smple frst-best rule of unform emsson prcng remans a practcal gudelne for unlateral clmate polcy desgn. But systematcally checkng possble ways of dfferentatng carbon prces across fuels and end-use sectors, Boeters (2014) shows that the optmal pattern of carbon prces n unlateral European clmate polcy s hghly dfferentated and offers substantal welfare gans relatve to unform prcng (equvalent to a 27% emssons reducton for free). 2 Our paper adds to the lterature by dentfyng a poltcally relevant case where 3 2 Boeters (2014) fnds that the most mportant drvers for carbon prce dfferentaton are market power n export markets and taxes on consumpton, ntermedate nputs, and domestc outputs. At the same tme, he warns that hs model vews taxes as dstortve neffcences and shows that hs case for carbon prce dfferentaton weakens f hs model channels tax revenues on motor fuels to road constructon and mantenance and assumes that these have to be provded n proporton to motor fuel consumpton.

4 4 carbon prce dfferentaton s effcent and by determnng the optmal level of carbon prce dfferentaton. The remander of the paper s organzed as follows. Secton I descrbes our quanttatve framework, ncludng data, model structure, and calbraton. Secton II presents the desgn for our computatonal experments. Sectons III V present smulaton results and dscuss the relevance of the varous motves for carbon tax dfferentaton. Secton VI concludes. I. Quanttatve Framework Ths secton provdes an overvew of the numercal general equlbrum model used for our analyss. We frst descrbe the varous underlyng data sources and how we combne them for the purpose of model calbraton. We then brefly descrbe the model structure and hghlght ts key features. A. Data Ths study makes use of a comprehensve data set whch combnes survey data descrbng sngle households and natonal accounts descrbng spendng and ncome of ndustres, the government and households n aggregate. On the household sde, a representatve sample of the Swss populaton of households s portrayed by the Swss Household Budget Survey Haushaltsbudgeterhebung (HABE). The aggregate value flows are gven by the Socal Accountng Matrx data for the Swss economy, and they are complemented by physcal energy flow data from the NAMEA (Nathan et al., 2013). MICRO-HOUSEHOLD DATA FROM THE HABE SURVEY. The HABE data s a representatve survey of the permanent resdent populaton of Swss households whch s conducted every year on an annual bass by the Swss Federal Statstcal Offce (BFS). It collects nformaton about consumer behavour and the ncome of prvate households n Swtzerland; about households take part each year. 3 To ncrease sample sze, our underlyng data set aggregates three waves of survey data from the consecutve years (BFS, 2012a, 2012b, and 2013a). For the aggregaton over multple years, household data we use weghts publshed by BFS (2014). Indvdual households are aggregated nto 14 representatve household groups whch are ncluded as separate economc agents n the numercal equlbrum model (see also Table 1). For wage and salary earners, we dstngush ten household groups based on ncome decles; retred households are splt nto four groups representng ncome quartles. The ndvdual households are mapped to aggregated household groups accordng to an ndcator for the standard of lvng comprsng nformaton on total household ncome and expendtures. The ndcator controls for household sze by means of the OECD-modfed equvalence scale, an equvalence scale used by the OECD (2009) and orgnally proposed by 3 Household data s weghted accordng to the ncluson probablty as well as takng nto account certan other varables whch may lead to a household not takng part n the survey.

5 5 Table 1. Overvew of model resoluton: sectors, electrcty generaton technologes, and household groups. Sectors ( I) Non-energy Energy supply & converson Fnal demand Electrcty generaton technologes (p P ) Agrculture (agr), Pulp, paper and paper products (pap), Chemcals and chemcal products (che), Rubber and plastc products (pla), Other non-metallc mneral products (nme), Basc metals (bme), Fabrcated metal products, except machnery and equpment (fmp), Medcal, precson and optcal nstruments, watches and clocks (med), Other manufacturng (man), Servces (ser), Constructon (cns), Transportaton (excludng ar transportaton) (trn), Ar transporton (atp) Motor fuels (to), Heatng fuels (ol), Crude ol (cru), Coal (coa) Natural gas (gas), Electrcty generaton (ele), Electrcty dstrbuton & transmsson (edt), Electrcty from waste ncneraton (ew), Heat from waste ncneraton (hw) Prvate consumpton by 14 representatve households, government consumpton, nvestment demand Hydro, Pump hydro storage facltes, Gas, Nuclear, Ol, Solar, Wnd, Bomass, Geothermal, Combned heat and power Household groups Wage and salary earners grouped by annual ncome decle wth (h H) EH1 (=lowest decle) to EH10 (=hghest decle) Retrees grouped by annual ncome quartles wth RH1 (=lowest quartle) to RH4 (=hghest quartle) Notes: Indcates sectors whch are subject to the Swss emssons tradng system for energy-ntensve ndustres. Hagenaars, de Vos and Zad (1994). 4 NATIONAL ECONOMIC ACCOUNTS AND ENERGY DATA. We use the Swss Input- Output (IO) table for the year 2008 (BFS, 2011) n the verson by Nathan et al. (2013) whch provdes nformaton on economc transactons among busnesses, households, and government agents. Besdes a detaled dsaggregaton of the energy and transportaton ndustres, ths verson ncludes supplemental physcal accounts for energy producton and consumpton whch are consstently lnked wth economc data n value terms and to keep track of CO 2 emssons derved from physcal energy quanttes. In ts orgnal form, the IO table dstngushes 66 ndustres and commodty groups and 20 categores for fnal demand. Table 1 provdes an overvew of our commodty aggregaton. We dentfy nne sectors of energy supply and converson separatng varous fuels (motor and heatng fuels, natural gas, coal, crude ol) and secondary energy supply (comprsng varous forms of electrcty and heat). The choce of aggregaton for the 13 non-energy sectors s guded by the consderatons to separately dentfy sectors whch are large n terms of economc sze (.e., value of output), exhbt a hgh energyntensty, or are subject to the Swss emssons tradng system (ETS). Three fnal demand sectors represent prvate and government consumpton, and nvestment demand. Based on the socal accountng data, our model further ncludes payroll 4 Ths scale assumes the exstence of economes of scale n household consumpton. The mappng of households nto groups s based on the reference person of the household whch s defned to be the person wth the hghest ncome n that household.

6 6 taxes ( AHV-Beträge ), prvate ncome taxes, value-added taxes, mport tarffs by commodty, sector-specfc output taxes and subsdes, and energy-related taxes ncludng mneral ol taxes. INTEGRATING MICRO-HOUSEHOLD SURVEY DATA AND IO DATA. Integratng the mcro-household survey data n the macroeconomc model requres an exact match between natonal aggregates of demands and ncomes by sngle households and aggregate nformaton on household consumpton and revenue accordng to the natonal accounts. Natonal consumpton n terms of COICOP (Classfcaton of Indvdual Consumpton Accordng to Purpose) categores accordng to the IO data was then mposed on the household data by scalng household consumpton by the approprate factor for each consumpton category. Smlarly, household data on wage ncome was scaled to meet the natonal aggregate. For ncome through captal rents, t had to be taken nto account that not the whole operatng surplus of ndustres can be assocated wth ncome for households, as some of t wll be renvested drectly. Our benchmark assumes that about half of the operatng surplus generates actual ncome to households, whle the remander s drectly renvested. Savng behavor s also represented n the household survey and was scaled to match aggregate household savng from the IO table. The remanng dfference between ncome and expendture of households was attrbuted to drect transfers to or from the government. B. Model The key features of our mult-sector, mult-household comparatve-statc numercal general equlbrum model of the Swss economy are brefly outlned below. Appendx A contans a complete algebrac descrpton of the model s equlbrum condtons. PRODUCTION TECHNOLOGIES AND FIRM BEHAVIOR. In each ndustry, gross output s produced usng the prmary nputs labor and captal and domestcally produced or mported ntermedate nputs. We employ constant-elastcty-ofsubsttuton (CES) functons to characterze the producton systems. All ndustres except electrcty generaton are characterzed by constant returns to scale. The nestng structure of producton sectors s depcted n Fgure 1a. Power generaton s modeled usng a smple bottom-up approach where output from each technology s produced by combnng technology-specfc captal wth nputs of labor, fuel, and materals. Electrcty generaton from dfferent technologes s treated as a homogeneous good and power supply by the technologes s determned by calbrated prce elastctes of supply. The IO data provdes nformaton to calbrate producton functons for electrcty generatng technologes that have been actve n 2008: hydro storage, runnng hydro, nuclear, photovoltacs, wnd, bofuel, heat-and-power co-generaton, and other fossl fuel plants. Geothermal and combned cycle turbnes technologes are ncluded and may become actve n the future (dependng on baselne assumptons and ther respectve prce elastcty of supply).

7 7 Fgure 1. Nested structure for producton and consumpton actvtes (a) Producton Transport σ TR PD σ TOP Non-transport σ NTR PAS trn, PAS benz, VA-Energy σ VAE Intermedates σ MAT VA σ VA Energy σ EN... PAS j,... PK PL PAS edt, Non-ELE σ FF PAS col, Non-coal σ LQ PAS ol, PAS gas, (b) Consumpton Transport σ CTR PC hh σ CTOP Non-transport σ CNTR PAS trn,hh PAS benz,hh Energy σ CEN Intermedates σ CMAT PAS edt,hh Non-ELE σ CFF... PAS j,hh... PAS col,hh Non-coal σ CLQ PAS ol,hh PAS gas,hh

8 8 Gven nput prces and taxes, frms mnmze producton costs subject to the technology constrants. Frms operate n perfectly compettve markets and maxmze ther profts by sellng ther products at a prce equal to margnal costs. Fossl fuel resources and power technology captal are treated as sector-specfc and n fxed supply, whereas captal outsde the power sector and labor are treated as perfectly moble across sectors wthn Swtzerland. Our model assumes that Swss and foregn nvestors vew nvestments nsde or outsde Swtzerland as perfect substtutes. Ths mples that rents on broad captal are constant and determned by the real exchange rate. PREFERENCES AND HOUSEHOLD BEHAVIOR. Gven goods and factors prces, households maxmze ther utlty by allocatng ncome receved from government transfers, wages and rents on captal to consumpton. Preferences for each representatve household group are descrbed by a nested CES utlty functon of consumpton goods (see Fgure 1b). Households dffer n terms of ther expendture and ncome patterns. Labor supply and savngs are assumed to be fxed. INTERNATIONAL TRADE, GOVERNMENT, AND INVESTMENT. Wth the excepton of crude ol, whch s a homogeneous good, domestc and mported versons of goods are dfferentated followng the Armngton assumpton (Armngton, 1969): for each commodty, total market supply s a CES composte of a domestcally produced varety and an mported one. Swss mports and exports do not affect world market prces. Swtzerland s assumed to keep ts trade balance constant and the supply of exports together wth demand of mports determne the real exchange rate at whch Swss trade nteracts wth the global market. A sngle government entty approxmates government actvtes at all levels (federal, cantonal, and local). Aggregate government consumpton s represented by a Leontef composte and s fnanced by tax and tarff revenues. Lke government consumpton, the composte nvestment good s modeled usng a fxed coeffcent producton functon. II. Desgn of Computatonal Experments A. Busness-as-usual reference scenaro and forward calbraton The economc effects of carbon prce dfferentaton depend on the baselne condtons for the future Swss economy. In our comparatve-statc framework, we nfer the baselne structure of the Swss economy for 2008 based on hstorc data sources (as descrbed n Secton I.A). In a second step, we calbrate the 2008 economy forward to the target year 2030, employng estmates for GDP growth, energy demands, emssons, autonomous energy effcency mprovements, technologcal change n the power sector, and changng fuel prces on the world market. 5 Fnally, our reference scenaro assumes contnuaton of the exstng ETS polcy whch regulates emssons from energy ntensve sectors (see Table (2002). 5 Ths type of forward calbraton procedure has been used, for example, n Böhrnger and Rutherford

9 1 for the sectors that are regulated under the ETS n our model); we assume that the annual cap s reduced by 1.74 percentage ponts each year based on the current trajectory for the ETS cap. 6 Table B1 n Appendx B summarzes our assumptons that underle the forward calbraton n the busness-as-usual (BaU ) reference scenaro. In the busness-as-usual scenaro, total emssons amount to 33 Mt CO 2 n 2030; ths corresponds to a reducton of about 21.5% relatve to Thus, further polcy measures are necessary for reachng the targeted reducton of 40% wth respect to B. Alternatve carbon prcng schemes The desgn of our polcy scenaros s motvated by carbon tax proposals under dscusson n Swtzerland (Federal Councl, 2015a). Three types of carbon prcng polces are currently consdered that dffer wth respect to the fuel that s taxed and the sectoral scope: (1) a carbon prce for energy-ntensve sectors ncluded under the Swss ETS, and (2) a carbon tax on thermal fuels (ncludng natural gas, heatng ol, coal, and other petrol products) n the non-ets sectors, (3) a carbon tax on motor fuels n the non-ets sectors. Aganst ths background, we analyze polcy scenaros where emssons n the ETS are capped and overall emsson targets are reached by settng endogenous but dfferentated CO 2 taxes on fuels consumed outsde the ETS. Our sx scenaros can be descrbed as follows (Table 2 provdes a summary of ther man characterstcs): Transport: Only motor fuels (of non-ets ndustres) are taxed, whle thermal fuels are not. Emssons from ETS ndustres are subject to the ETS cap and ts resultng endogenous permt prce. Thermal: Only thermal fuels (of non-ets ndustres) are taxed, whle motor fuels are not. Emssons from ETS ndustres are subject to the ETS cap and ts resultng endogenous permt prce. Dfferentated: Motor and thermal fuels (of non-ets ndustres) are taxed at dfferent rates. The rato of 7/30 (=0.24) between motor and thermal fuel taxes s gven by exstng polcy proposals (Federal Councl, 2015a). Emssons from ETS ndustres are subject to the ETS cap and ts resultng endogenous permt prce. Unform ETS: Emssons from motor and thermal fuels (of non-ets ndustres) are unformly taxed. Emssons from ETS ndustres are subject to 6 See CO 2 Verordnung (Anhang 8 zu Art. 45 Abs. 1) whch regulates the Swss ETS untl We assume the same rate of change after The target s formulated n terms of all greenhouse gas (GHG) emssons and requres a reducton of at least 50% by 2030 relatve to 1990 of whch at least 30% should come from domestc reductons. Reducng all GHGs domestcally by 30% corresponds to 40% domestc reducton of CO 2 (Federal Councl, 2015a). 9

10 10 Table 2. Man characterstcs of carbon prcng scenaros Scenaro Thermal Transport Tax rato Cap on ETS label fuel tax fuel tax transport/thermal ndustres Transport No Yes 1/0-40% Thermal Yes No 0/1-40% Dfferentated Yes Yes 7/30-40% Unform ETS Yes Yes 1/1-40% Unform Yes Yes 1/1 endogenous Optmal Yes Yes endogenous endogenous the ETS cap and ts resultng endogenous permt prce whch lkely dffers from the one on motor and thermal fuels. Unform: All carbon emssons, ncludng those from the ETS ndustres, are unformly taxed. There s one reducton target for the whole economy and no separate ETS cap. Optmal: Carbon prces for motor and thermal fuels n non-ets ndustres are optmally dfferentated. Emssons from ETS ndustres are subject to an optmally set ETS cap and ts resultng permt prce. When comparng the alternatve carbon prcng schemes lsted above, we always assume that the same economy-wde emssons target has to be met. Dfferentated and Thermal represent polcy scenaros that have been proposed by the Federal Councl (2015a). The scenaro Transport s nether poltcally realstc nor can t be expected to be effcent, but t contrasts the Thermal scenaro and together wth t spans the range of dfferent levels of CO 2 tax dfferentaton. The scenaro Unform represents the most effcent polcy desgn n a frst-best world wthout pre-exstng dstortons or other externaltes. The scenaro Unform ETS s expected to be somewhat less effcent but more realstc than the scenaro Unform as t assumes that the Swss ETS contnues to exst n the future. Fnally, the Optmal scenaro allows us to contrast the scenaros that reflect proposed Swss carbon polces wth a case whch optmally dfferentates carbon prces of motor and thermal fuels wthn the non-ets sectors and chooses an optmal ETS cap to acheve a gven reducton target at the lowest possble costs. Our analyss assumes throughout that the revenues from CO 2 taxes are redstrbuted to households and ndustres. We follow here closely the redstrbuton scheme proposed by Swss polcy (Federal Councl, 2015a) whch assumes that the carbon revenue from the Swss ETS and from taxng ndustres s returned to ndustres n proporton to wage payments (through reductons on the socal securty bll). Carbon revenues from taxng households fuel consumpton are recycled to households n a lump-sum fashon on a per-capta bass. In addton, we assume that government spendng s held fxed n real terms. 8 8 We mplctly assume separablty of publc spendng and prvate consumpton n households utlty

11 11 Fgure 2. Margnal welfare costs of abatement (lnes) and CO 2 prces (dots) for alternatve carbon prcng schemes III. Carbon Tax Dfferentaton and Pre-exstng Dstortonary Taxes In the dscusson of results, we frst focus on the case where the source for dstortons n an otherwse effcently runnng economy s the exstng tax system. We compare total and margnal welfare abatement costs under optmally dfferentated and prevously proposed carbon prcng schemes. We also provde ntuton for our effcency results by analyzng fuel- and sector-specfc CO 2 abatement patterns. A. Margnal and total welfare abatement costs MARGINAL WELFARE COSTS AND CO 2 PRICES. When ntroducng CO 2 taxes n a frst-best economy wthout pre-exstng taxes and externaltes, t s a wellestablshed result that CO 2 prces correspond to margnal welfare costs (MWC) of functon, and refran from modelng explctly a publc good. In ths settng, any meanngful welfare analyss has to hold the level of real government spendng fxed. Constant government spendng s acheved by usng a non-dstortonary lumpsum tax nstrument. The amount of carbon revenue that can be recycled to the economy s thus net of any tax base eroson effects that result from lower revenues of non-co 2 taxes.

12 12 abatement and that unform taxaton of all CO 2 emssons leads to an equalzaton of margnal abatement costs and thus mnmzes costs (see, for example, Metcalf, 2009). In the presence of dstortonary taxes, CO 2 prces understate MWC of abatement (Bovenberg and Goulder, 1996). To develop an understandng of the quanttatve mportance of potental tax nteracton effects n the Swss economy, Fgure 2 characterzes the margnal abatement costs and CO 2 prces assocated wth each carbon prcng scheme. Several mportant nsghts emerge. Frst, comparng MWC, t s evdent that reducng carbon n the transportaton sector s sgnfcantly more expensve as compared to taxng thermal fuels. The reason for ths s that transportaton demand s hghly prce-nelastc relatve to the demand for thermal fuels and that pre-exstng taxes already made consumers use the cheapest optons for reducng fuel use. 9 Comparng MWC and correspondng CO 2 prces for the Transport scenaro suggests a szeable tax nteracton effect that arses when mposng a CO 2 tax on motor fuels. For a 30% emssons reducton, the MWC costs are about 1.8 tmes larger than the CO 2 tax: 882 CHF/ton CO 2 (MWC) versus 485 CHF/ton (CO 2 tax). In contrast, when the same emssons reducton s acheved by taxng only thermal fuels, tax nteracton effects are small. In the Thermal scenaro MWC are 278 CHF/ton CO 2 and the tax rate s 255 CHF/ton CO 2 for a 30% emssons reducton. As the Unform scenaro nvolves taxng both thermal and motor fuels, t represents an ntermedate case wth the dfference between MWC and the tax rate beng smaller than n the Transport but larger than n the Thermal scenaro. The reason for the partcularly large tax nteracton effect assocated wth motor fuels s the hgh mneral ol tax n Swtzerland. 10 Second, for suffcently low emssons reductons, dfferentatng CO 2 prces between motor and thermal fuels yelds sgnfcantly lower MWC. For example, for a 25% reducton, the MWC for Unform are about 2.6 (2) tmes large than under Thermal (Dfferentated). The MWC rankng, however, reverses for hgh abatement targets n excess of 35%: wth an ncreasng strngency t becomes optmal to eventually also tax motor fuels more and more despte the adverse tax nteractng wth the mneral ol tax. As a result, unform carbon prcng has lower MWC for relatvely hgh emssons reducton targets. Thrd, as the ETS cap s exogenously set ndependent of the overall emssons reducton target, the Unform ETS scenaro s lkely to lead to MWC that dffer from those obtaned under unform emssons prcng (even f tax nteracton effects are absent). For low reducton targets, the welfare costs of reducng an addtonal ton of CO 2 are lower than under the Unform scenaro as t s poss- 9 Whle the magntude of MWC dfference between the transportaton and non-transportaton sectors depends of course on the specfc technology assumptons for modellng the transportaton sector, the fndng that margnal abatement costs n the transportaton sector tend to be relatvely hgher n the transportaton sector s n lne wth prevous studes (see, for example, Paltsev et al., 2005a; Abrell, 2010; Karplus et al., 2013). 10 As of 2015, the mneral ol tax on motor fuels s CHF per ltre whle the tax on thermal fuels s only CHF per ltre.

13 13 Fgure 3. Welfare costs of decarbonzaton for alternatve prcng schemes (relatve to BaU ) ble to explot relatvely cheap abatement opportuntes n the non-ets sectors. Wth more strngent emssons targets, more abatement has to come from the non-ets sectors at ncreasng margnal abatement costs, thus eventually leadng to hgher MWC for the Unform ETS scenaro. In fact, the pont where MWC curves for the Unform and Unform ETS scenaros ntersect shows the level of the economy-wde emssons reducton target for whch the exogenously set ETS target (.e., 40%) s optmal. TOTAL WELFARE COSTS. Whle a MWC perspectve s useful to dentfy for whch fuel there exst quanttatvely mportant tax nteracton effects, total welfare costs are what matters for decdng whch polcy opton to adopt. Fgure 3 reports total welfare costs for the dfferent carbon prcng schemes. A frst mportant nsght s that a substantal decarbonzaton of the Swss economy s possble at modest costs; for example, the annual costs of reducng CO 2 emssons by 40% by 2030 (relatve reducton to 1990 level) whch arguably seems to be n the range of the reductons targeted by current Swss polcy proposals are about 0.4% of annual consumpton or about 2.5 bllon 2008 CHF per year. Total welfare costs ncrease more than proportonally n the strngency of the carbon polcy, whch reflects that t becomes ncreasngly dffcult to substtute fossl energy wth non-carbon nputs n producton and consumpton actvtes. For example, ncreasng the emssons reducton goal by 10 percentage ponts from

14 14 Table 3. Welfare cost dfference relatve to economy-wde unform carbon prcng a Emssons Transport Thermal Dfferentated Unform ETS Optmal level b % % % % % Notes: a Welfare cost dfference measured as annual consumpton loss n bllon 2008 CHF. b Energyrelated CO 2 emssons n % relatve to 1990 level. 40% to 50% ncreases the annual welfare costs by a factor of three. Fgure 3 shows that the desgn of carbon prcng polces crtcally affects costs. Gven the hgh margnal abatement costs n the transportaton sector as well as the large adverse tax nteracton effect wth the mneral ol tax on motor fuels, t s not surprsng to see that mtgatng emssons by only taxng motor fuels are hghly neffcent (e.g., the total welfare costs under Transport are about than three tmes larger than under any of the other scenaros for a 35% reducton). 11 Table 3 compares the welfare costs of dfferent carbon prcng schemes relatve to the Unform scenaro whch would mnmze welfare costs n a frst-best settng wthout pre-exstng tax dstortons. The suggeston that dfferentatng carbon prces across motor and thermal fuels can yeld szeable effcency gans s borne out by the results n Table 3. The Optmal scenaro ndcates the maxmum effcency gans that can be obtaned through carbon prce dfferentaton (between motor and thermal fuels). Relatve to unform carbon prcng, optmally dfferentatng carbon taxes on motor and thermal fuels can yeld up effcency gans of up to 41%; for hgh reducton targets, the gans from tax dfferentaton dmnsh as more abatement s acheved through lowerng the use of motor fuels. The Dfferentated scenaro, whch closely represents the carbon tax structure proposed by Federal Councl (2015a), brngs about an effcency ncrease of up to 12% relatve to unform emssons prcng. However, for reducton targets of 45% and hgher, the proposed carbon tax polcy would mply addtonal welfare costs. Fnally, the scenaro Thermal s almost as effcent as Dfferentated. B. Optmally dfferentated CO 2 taxes In order to dentfy the optmal level of carbon tax dfferentaton (the Optmal scenaro), the contour lnes n Fgure 4 show welfare effects of dfferent ETS caps (vertcal axs) and tax rate ratos between taxes on motor and thermal fuels (horzontal axs) f the mplemented polcy has to reduce Swss CO 2 emssons by 40%. On the grd of analyzed polces, the smallest welfare loss s acheved by 11 Moreover, the numercal model faled to produce a soluton for reachng reducton targets of 40% and hgher n scenaros Transport or Thermal. Whle ths does not rule out that a soluton exsts, t llustrates the dffculty of reachng the targets by taxng on fuel type only.

15 15 Fgure 4. CO 2 tax dfferentaton between motor and thermal fuels for optmal and non-optmal carbon prcng schemes and alternatve emssons reducton targets ETS emssons (percent change from no-polcy) % -35% Thermal Dfferentated % -45% -50% /8 Rato motor fuel tax/thermal fuel tax Unform Transport Unform_ETS 10/6 10/4 10/2 10/0 Welfare changes from BaU (%): Notes: The red crosses ndcate the optmal tax dfferentaton (Optmal scenaro) for dfferent emssons reducton targets. The contour lnes portray the welfare losses (relatve to BaU ) of reachng a 40% emssons reducton wth dfferent ETS caps and dfferentaton levels of CO 2 taxes. The green dots locate non-optmal carbon prcng scenaros on the welfare loss surface. an ETS cap that s 40% below no-polcy emssons and a carbon tax on motor fuels that s 40% of the carbon tax on thermal fuels. We fnd the followng ponts worth hghlghtng. Frst, the optmal rato of carbon taxes on motor and thermal fuels s sgnfcantly below one and vares substantally wth the reducton target. For low reducton targets, t s optmal to almost not tax carbon emboded n motor fuels. Ths s due to the tax nteracton effect stemmng from the large mneral ol tax on motor fuels. Wth hgher reducton targets, the optmal tax rato ncreases but t remans markedly below unty even for ambtous reductons goals as hgh as 50%. Second, among the non-optmal prcng scenaros, the tax rato n the Dfferentated scenaro s the closest to the optmal polcy desgn (for a 40% reducton target). Ths also means that the unform emssons prcng scenaros (Unform and Unform ETS) devate substantally from the optmal tax dfferentaton across motor and thermal fuels. Thrd, the currently proposed ETS cap approxmately corresponds to a 40% reducton compared to our assumpton about no-polcy emssons and s well suted for reachng a cost-effectve reducton of economy-wde emssons by 40%. Ths also explans why, for a 40% reducton target, the Dfferentated scenaro s

16 16 almost as effcent as the Optmal scenaro: t s relatvely close to the optmal carbon prcng structure both n terms of dfferentatng CO 2 prces across the margns ETS vs. non-ets and thermal vs. motor fuels. Focusng on the welfare cost dmenson (contour plots), Fgure 4 provdes another nsght: Small mstakes n polcy desgn (e.g., choosng Dfferentated rather than Optmal) are sgnfcantly less severe n terms of effcency losses as compared to fundamentally flawed polcy desgns (e.g., choosng Thermal or Transport nstead of Optmal). C. CO 2 emssons and fuel- and sector-specfc abatement Fgure 5a reports the CO 2 emssons by fuel and by end-use sector under the BaU reference scenaro n About one half of CO 2 emssons stems from fossl energy use n the prvate household sector, the other half from ndustry use, wth about 11 Mt CO 2 comng from non-ets ndustres and 6 Mt CO 2 from ETS ndustres. In terms of fuels, the largest part of CO 2 emssons comes from motor fuels (36%), followed by gas (31%), lght fuel ol (18%) and other petrol products (14%). Fgure 5b shows the reductons per fuel type and end-use sector for alternatve carbon prcng schemes for a 40% reducton target. The trangles refer to the prmary vertcal axs and show the percentage change n emssons for the Optmal scenaro relatve to the BaU. Across all fuels, the largest percentage emssons reductons occur n the household sector and the non-ets ndustres whle emssons n the ETS ndustres are only slghtly reduced (reflectng the near optmal cap of 40%, already present n the BaU, for an economy-wde reducton target of 40%). It s mportant to note that whle transportaton emssons are reduced somewhat n both household ( 17%) and non-ets sectors ( 22%), the percentage reductons for all other, non-motor fuels are much larger. Two man nsghts emerge from comparng the pattern of emssons reductons among dfferent carbon prcng schemes (shown by respectve bars referrng to the secondary vertcal axs). Frst, the tax dfferentaton under Dfferentated leads to a relatvely smlar abatement pattern as under optmal tax dfferentaton. The abatement pattern s vrtually dentcal for the non-ets ndustres. For the household and ETS sectors the bggest dfference s that under Dfferentated there s less abatement n motor fuels and more abatement n thermal fuels as the Dfferentated assumes a lower motor-to-thermal fuel tax rato as what would be obtaned under Optmal tax dfferentaton (compare wth Fgure 4). Second, both scenaros wth unform emssons prcng (Unform and Unform ETS) produce relatvely large devatons from the optmal abatement pattern. In partcular, they enforce sub-optmally hgh emssons abatement n motor fuels and too lttle abatement n thermal fuels.

17 17 Fgure 5. CO 2 emssons by fuel and by end-use sector (a) Busness-as-usual CO 2 emssons n year 2030 (b) Change n CO 2 emssons for a 40% reducton target under alternatve carbon prcng schemes

18 18 IV. Carbon Tax Dfferentaton and Dstrbutonal Impacts: Is There an Effcency-Equty Tradeoff? Besdes effcency consderatons, an mportant crteron for assessng alternatve carbon prcng desgns s dstrbutonal equty. In fact, the publc acceptance for carbon taxes crucally depends on ther dstrbutonal consequences. One major concern s typcally that the ncdence of energy taxes may be sharply regressve wth dsproportonately large burdens fallng on low-ncome households. 12 Ths typcally holds true f cost of electrcty and heatng ncrease but less so f costs of transportaton do. Thus, whle taxng motor fuels less than thermal fuels may be desrable from an effcency pont of vew, dfferent prcng schemes may lead to dvergent outcomes n terms of how the economc burden (or gans) are dstrbuted across household groups. Unntended dstrbutonal consequences would then have to be traded-off aganst possble effcency gans. A. Household expendture and ncome patterns Spendng patterns n Swtzerland agree wth fndngs n other countres n that low ncome households spend the largest share of energy-related expendtures on heatng and electrcty whle the hgh ncome households have the largest expendture share for transport fuels. Fgure 6a reports the energy-related annual expendture shares for the ncome decles of wage and salary earners and ncome quartles of retred households n Swtzerland. Expendture shares for natural gas and electrcty declne wth ncome whle expendture shares for heatng ol do not vary much wth ncome. Expendture shares for motor fuels are the hghest for most households (wth the excepton of the two bottom quartles of retred households) and ncrease wth ncome. The uses sde of ncome mpacts of a carbon tax on thermal fuels are thus lkely to be regressve whle those of a carbon tax on motor fuels are lkely to be progressve. The overall ncdence, however, also depends on the sources sde of ncome mpacts. Fgure 6b ponts to the fact that there s substantal heterogenety among household ncome groups wth respect to ther sources of ncome. In partcular, the top ncome decles for wage and salary earner exhbt much larger captal and much lower labor ncome shares; ths pattern s even more pronounced across ncome quartles of retred households. In addton, the share of household ncome from government transfers decreases wth ncome. 12 Varaton n mpacts arse for, at least, three reasons. Frst, households dffer n how they spend ther ncome. Carbon prcng wll rase the prce of carbon-ntensve commodtes and dsproportonately mpact those households who spend larger than average shares of ther ncome on these commodtes. Second, carbon prcng also mpacts factor prces. Households whch rely heavly on ncome from factors whose factor prces fall relatve to other factor prces wll be adversely mpacted. In the publc fnance lterature on tax ncdence, the frst mpact s referred to as a uses of ncome mpact whle the latter a sources of ncome mpact (see, for example, Atknson and Stgltz, 1980). Thrd, the ncdence of a carbon tax s also affected by the how the government returns the carbon revenue to the economy.

19 19 Fgure 6. Energy-related expendture shares and ncome shares by household ncome groups (a) Energy-related expendture shares (b) Income share by source of ncome

20 20 Fgure 7. Normalzed dstrbuton of welfare mpacts for carbon tax on only thermal or only motor fuels (for 35% emssons reductons) B. Motor vs. thermal fuels Fgure 7 shows the welfare mpacts for each household ncome group for carbon prcng schemes that put a carbon tax on ether motor fuels or thermal fuels. To focus on how dstrbutonal equty s affected, welfare mpacts are normalzed (relatve to the respectve mddle ncome groups for both sets of households). We also report cases n whch the carbon revenue s not returned back to households or the ndustry. 13 The cases wthout revenue recyclng are useful to llustrate the ncdence of carbon prcng tself wthout confoundng the analyss wth mpacts that are drven by assumptons on how the revenue s returned. Wthout revenue recyclng, we fnd that a carbon tax on motor fuels s slghtly progressve for workng households, but less so for retred households. In contrast, a thermal fuel tax s slghtly regressve to almost neutral for workng households and markedly regressve for retred households. The small regressvty for workng households s due to the sources sde of ncome mpacts whch are progressve: on average, lowered returns to captal are absorbed more by hgh-ncome households whch derve a relatvely large share of ncome from captal. Redstrbutng the 13 In ths case, we assume that government spendng s ncreased by an equal amount.

21 21 Fgure 8. Welfare mpacts for alternatve carbon prcng schemes (for 35% emssons reductons) carbon tax revenue on a per capta bass to households makes the overall tax ncdence sharply progressve for both sets of households. Assumng that more equtable outcomes are socally more preferable than outcomes wth more dspersed (ether regressve or progressve) mpacts, we thus do not fnd evdence for an effcency-equty tradeoff as far as the choce between a carbon tax on thermal or motor fuels s concerned: a tax on motor fuels s less effcent than a tax on thermal fuels and leads to a more dspersed dstrbutonal outcome. Hence, a hgh carbon tax on motor fuels seems to be undesrable from both an effcency and equty pont of vew. C. Mxed carbon prcng schemes Nether taxng only thermal fuels nor taxng only motor fuels wll acheve the ambtous CO 2 emssons reducton targets (.e, 40% and hgher) set out under Swss clmate polcy at reasonable cost. Carbon prcng schemes are thus lkely to eventually nvolve carbon taxes on both fuel categores. Fgure 8 shows the dstrbutonal welfare mpacts relatve to the BaU for the Optmal, Dfferentated, and the two unform carbon prcng schemes. Whle there are notceable dfferences wth respect to effcency (as has been dscussed above), t s mportant to note that the shape of the mpact patterns s largely smlar. The reason s that ncdence results are domnated by the welfare mpacts.

22 22 An mportant mplcaton for polcy s thus that the polcy desgn n the context of dfferentated carbon prcng should prmarly focus on effcency aspects and less on dstrbutonal equty. V. Carbon Tax Dfferentaton n the Presence of Non-CO 2 Externaltes of Motor Fuel Use Our analyss has so far vewed all pre-exstng taxes as dstortons n an otherwse effcently runnng economy. We have dentfed the pre-exstng mneral ol tax as the reason to dfferentate CO 2 taxes between dfferent fuel types to mprove over unform emssons prcng. Whle one major purpose of the mneral ol tax s of course to rase revenue for road constructon, road traffc has several non-clmate related externaltes such as, for example, local and global ar polluton, nose polluton, traffc congeston, and traffc accdents (Calthrop and Proost, 1998; Parry, Walls and Harrngton, 2006) whch may be nternalzed through Pgouvan prcng (see, for example, Parry and Bento, 2002; Anas and Lndsey, 2011). Such a Pgouvan tax would make transportaton actvtes more expensve by the value of external damages these actvtes nflct on thrd partes through non-market based nteractons. As our model does not consder such transportaton externaltes, our analyss so far may have msjudged the overall effects of alternatve CO 2 tax dfferentaton schemes: whle nteractons wth the mneral ol tax calls for a lower carbon tax on motor fuels, a hgher carbon tax reduces transportaton actvtes, n turn reducng non-co 2 externaltes. A. Socal welfare functon and emprcal specfcaton To gauge the mportance of omttng such externaltes, we defne the socal welfare functon W n a way that ncludes utlty derved from prvate market consumpton and averted damages from non-co 2 transportaton externaltes: W (C h, A motor ) = h C h β(a motor Āmotor), where A motor s the actvty level of motor fuel use n the Swss economy, Ā motor ts baselne level, and C h s the purchasng power-adjusted consumpton level of household h. 14 We moreover assume that welfare s separable n market consumpton and the transportaton externaltes Ths assumes that the margnal damages from the transportaton externalty s constant and that t s drectly lnked to fuel use. Both assumptons need to hold at least locally, f a Pgouvan tax on motor fuels that s not regularly adjusted s to be a reasonable polcy measure to correct the externalty. 15 Of course, ths s a smplfyng assumpton. For example, people who have been n traffc accdents are lkely to change ther consumpton of health servces and people who experence changes n traffc nose n ther neghborhood are lkely to change ther nvestment behavor n sound nsulaton. Relaxng the assumpton of separablty would call for a more n-depth analyss whch s beyond the scope of ths paper.

23 23 Fgure 9. Optmal tax dfferentaton between motor and thermal fuels n the presence of non-clmate related transportaton externaltes ETS emssons (percent change from no-polcy) Thermal Dfferentated % -35% -40% Unform -45% Transport Unform_ETS -50% /8 Rato motor fuel tax/thermal fuel tax 10/6 10/4 10/2 10/0 Welfare changes from BaU (%): Notes: The red crosses ndcate the optmal tax dfferentaton (Optmal scenaro) for dfferent emssons reducton targets. For a 40% emssons reducton, the green dots show the non-optmal carbon prcng schemes and the contour lnes portray the correspondng welfare losses (relatve to the BaU ). β denotes the margnal loss n welfare due to non-co 2 related transportaton externaltes. What s an emprcal plausble value for β? Exstng studes ndcate that the externaltes caused by transportaton are more than hgh enough to justfy a Pgouvan tax of the magntude of the mneral ol tax (ARE, 2014). 16 To avod confoundng the ssue of settng the correct Pgouvan tax rate wth questons about tax nteractons, we assume that the mneral ol tax for 2030 ndeed corresponds to the Pgouvan tax rate. We then calbrate β such that the margnal loss n welfare from transportaton actvtes corresponds to the tax payments on fuel consumpton by these actvtes. 16 A study of the Swss Federal Offce for Spatal Development (ARE, 2014) has shown that prvate transportaton caused externaltes (ncludng traffc congeston, ar polluton, clmate-related costs, and others) of CHF 6.6 bllon n 2010 of whch 81.2 percent were not clmate related. Accordng to ths study, the total external costs per person klometer are CHF and the non-clmate part of ths s CHF per person klometer. Ths translates to externaltes of about CHF 1.23 per lter of motor fuels whch s well above the current level of the mneral ol tax. In 2010, new prvate vehcles n Swtzerland on average carred 1.6 persons and used 6.4 lters of gasolne per klometer (BFS, 2013b). Thus, prvate transportaton delvers at least 25 person klometers per lter of gasolne. The costs of non-co 2 related transportaton externaltes can then be estmated to be about CHF per lter of gasolne.