Übung 3

GHG tax leads to a permanent decline in future productivity. Forward-looking agents will anticipate a drop in future profits and income due to higher expected future energy prices and will cut investment and consumption accordingly.

Investment in carbon-intensive capital will drop as firms adjust to the soon-to- become-obsolete capital stock. Investment in renewables and associated capital increases but not enough to offset

the drop in carbon-intensive capital. The price of energy in general increases. If lump-sum transfers are large, consumption increases in the short term, but the effect is short-lived. In the medium to long term, consumption declines as well owing to the tax’s impact on households’ permanent income.

In the short to medium term, while the tax is still low, lower aggregate demand dominates the increase in energy costs, and a central bank focused on stabilizing core inflation will want to accommodate the shock.

GHG taxes generate fiscal revenues that can be used to:

1. help accelerate the transition, through incentives, subsidies, and public

investment;

2. cushion the taxes’ effect on firms’ output and household income; or

3. compensate low-income households through targeted transfers.

These options are part of fiscal policy, and countries will choose among them in line with their preferences and political economy considerations.

The following illustrates the implications of these choices for macroeconomic outcomes. Figure 3.3 contrasts three different strategies by which GHG tax revenues are recycled in the economy, by:

1. reducing distortionary labor income taxes,

2. subsidizing production by sector to offset the effect of the tax and provide incentives for the transition to less-carbon-intensive energy (akin to a “feebate”), or

3. simply rebating the tax’s proceeds to households.

Policy Package 1, by using two-thirds of GHG tax revenues to cut labor income taxes, focuses on the need to engineer the required decarbonization without overly penalizing consumption. Relatively higher GHG taxes are required to provide incentives for reallocation toward less-carbon-intensive production processes, and investment declines more than in the other packages.

Policy Package 3 focuses on supporting firms during the transition. The transition is then relatively smooth in terms of investment, which drops much less than in Policy Package 1. Because tax receipts are entirely rebated to firms, households bear the brunt of the tax-induced slowdown, and the consumption to investment ratio declines.

Policy Package 2 can be seen as a combination of Policy Packages 1 and 3, as it complements measures to support households during the transition with subsidies to low-emission sectors (renewables, nuclear and hydro power plants, and purchase of electric vehicles). Subsidies support investment more than in Policy Package 1. Using the revenues for subsidies comes at the expense of consumption, as it reduces the allocations to tax cuts and transfers. Moreover, because Policy Package 2 offers incentives for investment, the required emission reduction can occur with lower GHG taxes and therefore less inflation. This scenario illustrates that a strategy relying on large subsidies for low-emission technologies poses little risk of inflation.

importance of credible policy.

This subsection illustrates the importance of credible climate policy by relaxing the assumption of full credibility under Policy Package 1, with its gradually increasing GHG tax path.

Climate policy is assumed to be believed only gradually over time (partial credibility): more specifically, each increment of the GHG tax is expected to remain in place, but future increments of the GHG price path come as a surprise, thereby having no impact on households’ and firms’ current decisions.

For given GHG price paths, partial credibility slows down the emission reduction process relative to the full-credibility case (the cumulative emission reduction by 2030, expressed as a share of 2022 emissions, is about 20 percent lower under partial credibility than under full credibility; see Figure 3.5), as investment in emission-intensive capital does not decline as rapidly.

The key reason lies in the adjustment of investment in the electricity sector. When climate policy is fully credible, the anticipation of further GHG price increases— which will undermine future profitability—accelerates the shift of capital away from emission-intensive investments, such as coal power plants, toward low-emission alternatives.

Partially credible policy requires higher GHG taxes to reach the same decarbonization goal, leading to larger GDP losses by the end of the decade

• To keep the Paris Agreement’s goal within reach, GHG emissions must decline by 25 percent, with respect to current levels, by 2030. Achieving such a result would require unprecedented global effort and would represent a serious acceleration with respect to the past decade.

• The route to Paris could become more onerous unless a series of conditions are met.

First, the required climate policies need to be implemented immediately. Further delaying implementation will amplify the output-inflation trade-offs that central banks may face. An immediate start will allow a gradual process whereby GHG taxes can be increased in small and predictable increments, driving private expectations and behaviors and limiting inflationary pressures.

Second, it is important that new climate policy be credible. Credible climate policies offer incentives for investment and research and development in carbon-neutral technology and help accelerate the shift in consumption patterns toward low-carbon alternatives. International experience shows that rebating tax revenues to low-income households (which are bound to suffer the most from the new carbon pricing) helps bolster acceptance and reinforces such policies’ credibility.

Third, monetary policy credibility complements climate policy credibility and is essential to keep output-inflation trade-offs low. Doubts about central banks’ price stabilization credentials could lead to more widespread wage indexation and higher inflation inertia, which would further amplify output- inflation trade-offs and the cost of future stabilization. Concerns about current high inflation offer no justification for delaying necessary actions.

International coordination in GHG taxation could also allow faster decarbonization, as low-hanging fruit could be plucked in many countries that have not yet started decarbonization.

The price of energy in general increases. If lump-sum transfers are large, consumption increases in the short term, but the effect is short-lived. In the medium to long term, consumption declines as well owing to the tax’s impact on households’ permanent income.

GHG taxes generate fiscal revenues that can be used to:

1. reducing distortionary labor income taxes,

2. subsidizing production by sector to offset the effect of the tax and provide incentives for the transition to less-carbon-intensive energy (akin to a “feebate”), or

3. simply rebating the tax’s proceeds to households.

Facts:

Increasing the GHG tax increases the relative price of fossil fuels and, given that other prices in the economy do not move quickly, also increases the overall price level.

Production subsidies have a beneficial effect on investment but at the expense of consumption, as they preclude (prevent, rule out) transfers or tax cuts to households.

The three policy packages examined have different objectives, but all attempt a compromise in which energy transition is realized at a relatively low cost in terms of output and inflation. All packages allow for some income redistribution through transfers but combine different policy instruments and tax-recycling strategies.

Policy Package 1

• using two-thirds of GHG tax revenues to cut labor income taxes

• decarbonization without overly penalizing consumption

Policy Package 3

• focuses on supporting firms during the transition

• Because tax receipts are entirely rebated to firms, households bear the brunt of the tax-induced slowdown, and the consumption to investment ratio declines.

Policy Package 2

• combination of 1 and 3,

• support households during the transition with subsidies to low-emission sectors

• Subsidies support investment more than in Policy Package 1. Using the revenues for subsidies comes at the expense of consumption, as it reduces the allocations to tax cuts and transfers.

  
  

• Moreover, because Policy Package 2 offers incentives for investment, the required emission reduction can occur with lower GHG taxes and therefore less inflation. This scenario illustrates that a strategy relying on large subsidies for low-emission technologies poses little risk of inflation.

When climate policy is fully credible, the anticipation of further GHG price increases— which will undermine future profitability—accelerates the shift of capital away from emission-intensive investments, such as coal power plants, toward low-emission alternatives.

Partially credible policy requires higher GHG taxes to reach the same decarbonization goal

If monetary policy is not credible, any cost-push shock is bound to entail larger trade-offs. When monetary policy credibility prevents the de-anchoring of inflation expectations, a gradually implemented climate policy package will not give rise to a material output-inflation trade-off

1. First, larger annual increments in the GHG tax directly generate larger increases in headline inflation.

2. Second, a shorter transition period leads to a rapid fall in the utilization of capital for the production of fossil fuels, at a large cost to firms and their profitability.

3. Third, monetary policy credibility complements climate policy credibility and is essential to keep output-inflation trade-offs low. Doubts about central banks’ price stabilization credentials could lead to more widespread wage indexation and higher inflation inertia, which would further amplify output-inflation trade-offs and the cost of future stabilization. Concerns about current high inflation offer no justification for delaying necessary actions.

Therefore, if the concern is that higher GHG taxes may end up threatening central banks’ credibility, leading to larger output-inflation trade-offs, delaying climate policy does not appear to be a reasonable option. A risk management approach to monetary policy might instead suggest starting to implement the necessary GHG taxes right away and leaning against their impact on headline inflation. Doing so would minimize the risk that higher headline inflation will weaken the central bank’s credibility and lead to widespread wage indexation and higher inflation inertia.