Carrots and sticks in trade and climate policies

ABSTRACT

Tariffs or consumption tax hikes used in isolation engender consumption-based emission spillovers. A combination of these two instruments, if well designed, can offset these spillovers and would result in a zero-sum or win-win welfare outcome. The approach suggested here either strengthens deterrence against free-riders via stricter tariff sanctions or promotes climate cooperation via trade liberalization. The choice of trade and climate policy instruments depends, inter alia, on the relative strength of Home versus Foreign price responsiveness of demand.

KEYWORDS:

• Carbon leakage
• consumption taxes
• tariffs
• world demand effects
• public abatement

JEL CLASSIFICATION:

• F18
• H23
• H41
• Q54

Acknowledgements

The author would like to thank an anonymous referee for helpful comments on an earlier version of this paper.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 The fossil-fuel-price-induced carbon leakage has been studied by, for example, Markusen (1975), Felder and Rutherford (1993), Hoel (1996), Conconi (2003), Copeland and Taylor (2005).

2 Böhringer, Rosendahl, and Storrøsten (2017) focus on market-based carbon leakage and raise concerns about shifting consumption abroad by domestic consumption taxes. This leakage lowers the level of domestic consumption taxes (to alleviate output-based distortions).

3 Misch and Wingender (2021) say that production-based carbon emissions account for 60 percent of global carbon emissions and around 15 percent of global carbon emissions are from households’ electricity and fuel consumption. Consumption-based emissions leakage should not be taken lightly because a cap and trade does not cover households’ carbon emissions.

4 https://jp.reuters.com/article/eu-germany-climate-idAFL5N2N909Z

5 The present paper extends the consumption-neutral reform of Haibara (2012) to allow for cross border pollution and public pollution abatement.

6 Haibara (2021) considers unilateral tariff cuts and consumption taxes to neutralize domestic demand effects: to do so is to reduce Foreign consumption pollution. This paper, however, neither considers joint mitigation action, nor focuses on public pollution abatement.

7 Exiting numerical modelling studies (such as CGE models) have some mixed conclusions about the rate of leakage. Babiker (2005) finds leakage rates above 100%. Elliott et al. (2010) find that the range of a leakage rate is 15% to 25%. By contrast, Elliott and Fullerton (2014) find the existence of a negative leakage. As for the empirical literature, Aichele and Felbermayr (2015) empirically examine carbon leakage, showing that the Kyoto Protocol has indeed led to leakage. For a comprehensive review of the carbon leakage literature, see Misch and Wingender (2021).

8 Starting from the seminal work of Markusen (1975), the literature has focused on unilateral action to correct for carbon leakage (e.g. Keen and Kotsogiannis (2014), Böhringer, Rosendahl, and Storrøsten (2017) and Kruse-Andersen and Sørensen (2022)). A notable exception is the work of Copeland and Taylor (2005): they show that Home emission cutbacks increase Foreign environmental stringency via increased terms of trade and real income.

9 This implies that the tariff sanctioning package worsens Foreign welfare by more than tariffs alone.

10 In this case, $\mathrm{\alpha \tau }{E}_p$ is not earmarked to finance Home public abatement; rather it can be transferred to the foreign country. Although not explicitly analyzed above, this policy can be mutually welfare-improving if the merit of decreased carbon emissions is significant.

11 The proposed approach is robust to the type of pollution externalities. Consider production-based carbon emissions. The sanctioning policy of Proposition 1 lowers this leakage through decreased world prices. The trade liberalization policy of Proposition 2 also reduces this leakage mainly via increased public abatement. Note also that the qualitative nature of the results will go through when production tax hikes are used instead of consumption tax hikes.

12 The proposed policy, mutatis mutandis, applies to output-based rebate (OBR) because the combination of OBR and consumption taxes becomes a tariff (see Böhringer, Rosendahl, and Storrøsten (2017)).