The Design of a Carbon Tax in an Incomplete International Climate Agreement

Abstract

In a situation where all countries participate in an agreement to reduce CO2 emissions, taxes on consumption and production of fossil fuels have identical economic consequences, and cost efficiency suggests that a carbon tax should be equalized across all types of fossil fuels per unit of carbon. This is no longer true in an incomplete agreement, where a group of countries seeks to maximize its welfare, subject to a constraint on carbon emission from all countries. It is shown that when the cooperating countries use a tax on consumption of fossil fuels as the only policy instrument, the tax per unit of carbon should in general be differentiated across fossil fuels. When both production and consumption of internationally traded fossil fuels are taxed, a particular combination of producer and consumer taxes exists which is optimal. It is also shown that with this tax the sum of the consumer tax and producer tax should be equal across all fossil fuels per unit of carbon. We close the paper by giving an empirical illustration of the theoretical analysis, assuming that the cooperating countries are those of the OECD.