Fossil Fuel Subsidies, the Green Paradox and the Fiscal Paradox

Abstract

Fossil fuel subsidies amounted to about 0.4% of global GDP in 2015, and there is an active call worldwide for eliminating them. The main argument in favor of removing subsidies is that it will lead to a reduction in global carbon emissions and a decrease in fiscal deficits. This paper shows that there are also some overlooked adverse effects of eliminating the current fossil fuel subsidies. A version of the Green Paradox arises when oil firms learn that fossil fuel subsidies will be removed. In fear that their assets will lose value, firms have incentives to accelerate extraction before subsidies are eliminated. Thus, carbon emissions increase in the short run and the climate externality worsens. Likewise, a Fiscal paradox arises because government outlays rise in the short run when more extraction occurs. I show that these intertemporal effects reduce the relative benefits from eliminating the existing subsidies and may actually make a fossil fuel subsidy reform counterproductive.