Carbon Tax vs. Carbon Cap-and-Trade: Implementation of carbon border tax in cross-regional production

Abstract

Carbon Tax and Carbon Cap-and-Trade policies, as the primary carbon pricing instruments, are designed to reduce greenhouse gas emissions. However, inconsistent global regulations for emissions may lead to emissions leakage, as firms strategically relocate production to regions with less stringent controls. This study contributes to existing research by evaluating Carbon Tax and Carbon Cap-and-Trade policies in conjunction with the impending Carbon Border Tax (CBT), designed to mitigate emissions leakage from cross-regional production. Specifically, we examine a firm's equilibrium strategies in investment and production in both domestic and offshore regions under two different carbon pricing instruments while subject to the CBT. The analysis includes a comparative assessment of technology investment, total greenhouse gas emissions, and social welfare. Our findings indicate that the Carbon Tax policy can be associated with lower emission intensity, albeit generating greater total emissions compared to the Carbon Cap-and-Trade policy. Notably, the CBT can serve as an equivalent stimulant for technology investment and a reducer of aggregate emissions under both pricing instruments. Moreover, the Carbon Cap-and-Trade policy proves more beneficial in terms of social welfare when the firm's optimal strategy is confined to either domestic or offshore production. Conversely, the Carbon Tax policy yields higher social welfare in cases of high emission prices when the firm's optimal strategy is cross-regional production. The introduction of the CBT enlarges the set of conditions under which the Carbon Tax policy proves more advantageous for social welfare.