A UK carbon/energy tax: The macroeconomics effects

Abstract

A carbon/energy tax has been proposed by the European Commission to start as US$3 per barrel oil equivalent in 1993, rising to US$10 in 2000. The effects of this tax on the UK economy can be assessed by using a large-scale energy-environment-economy model in which energy demand is treated by means of aggregate equations for energy users and fuel share equations for electricity and each of the main fossil fuels. The electricity supply industry is represented in the model by simulating the characteristics of each existing generating station and of a range of new station types, and by allowing the model to choose the fuels used from relative fuel prices and prices of capital inputs. This approach contrasts with the multimodel approach used in most studies of the effects of the tax. The tax is introduced as a tax on imports and domestic output of fossil fuels in proportion to their carbon and energy content, with the tax being passed on through the economic system depending on the use of the fuels. Thus the electricity industry is faced with higher prices for coal, gas and fuel oil and chooses to burn the different fuels according to their relative prices. Four scenarios are developed, which vary according to the way the tax revenues are recycled through reductions in VAT or in income tax rates and whether the tax is introduced throughout the European Community or throughout the OECD. If the tax is European, it is assumed that the energy intensive industries will be exempt. The outcome is that the tax is sufficient to stabilize CO 2 emissions over the period 1990–2005, at 12% below base levels by the end of the period. There is an overall saving of energy compared to base and a further switch to gas in electricity generation. The effects on the macroeconomy are rather small, and as the revenues are recycled, rather than saved by the government, GDP growth is likely to increase under the tax by some 0.2% above base. This confirms other studies in which revenues are recycled, but contradicts many results from studies in which revenue recycling is ignored or incomplete. The effects on the energy intensive industries are expected to be small in all the scenarios, but 14% of tax revenues are lost if the industries are exempt.