Optimal Unilateral Carbon Policy

Samuel Kortum and David A. Weisbach

Key Findings:

The optimal regional carbon policy combines two principles. First, the policy combines taxes on supply of energy, such as an extraction tax, with taxes on the demand for energy, such as a tax on emissions from the use of energy in production or a tax on the consumption of the energy embodied in goods. The logic behind combining taxes on the supply and demand for fossil fuel energy is that these taxes have offsetting effects on the price of energy seen by Foreign. A tax on the extraction of fossil fuels results in fewer fossil fuels extracted domestically (reducing supply), raising the global price of energy and increasing extraction abroad. A tax on the use of fossil fuels in production or on the energy embodied in goods that are consumed makes these products and the production process more expensive, slowing production and reducing demand for these products at Home. With less demand, the global energy price goes down, resulting in traditional forms of leakage, such as an increase in production abroad and a loss of trade share. Combining taxes on extraction, production, and consumption allows Home to offset and balance these effects, minimizing the inefficiencies from leakage.

Second, the optimal policy maximizes the tax base, by including
all goods produced domestically (whether consumed at home or exported) and all goods consumed domestically, including all imports. Moreover, it expands its reach by subsidizing the export of lower carbon goods, to replace those produced abroad with a higher carbon intensity.

Implementing the optimal policy would consist of Home imposing:

1. A nominal tax on extraction equal to the social cost of carbon.
2. Carbon border adjustments on fossil fuels—taxes on fossil fuel imports and rebates on fossil fuel exports—as well as border adjustments on the energy content of other imports. The border adjustments would be at a lower rate than the extraction tax rate. This feature shifts a portion of the tax downstream to production and consumption, but because it is at a lower rate, maintains a portion of the extraction tax.
3. A subsidy for exports. The subsidy ensures that there is still the incentive for producing low-carbon goods, and even expands the export of such goods. The study compares the optimal policy to more conventional policies, such as taxes on emissions from domestic production or those taxes combined with carbon border adjustments. The simulations (Figure 1) show that the optimal policy is able to achieve two to three times the emission reductions for the same cost as conventional policies. Moreover, relatively simple policies built on the underlying principles of the optimal policy also significantly outperform conventional policies. In particular, a tax on domestic extraction combined with border adjustments on imports and exports of fossil fuels, but at a lower rate than the extraction tax (an extraction-production hybrid tax), would be simple to implement and performs nearly as well as the optimal tax.