Second-best Subsidy Research Articles

Fuel Subsidies Versus Market Power: Is There a Countervailing Second-Best Optimum?

Fuel subsidies distort end-use prices below cost, resulting in overconsumption and huge environmental cost. On the other hand, the mark-up over cost due to the exercise of market power results in the social loss of consumer surplus. We open a new line of inquiry into the potential for a market-based solution from these two countervailing forces: can the two offsetting distortions conceivably achieve a second- best optimum? Relying on dynamic panel techniques and gasoline market data for 68 developing countries, we uncover an excessive second-best subsidy offset to market power mark-up on the order of 4.5. Our results indicate that the potential for policy failure strongly exceeds the potential for market failure in our model, and gasoline prices across our sample may not be aligned with vigorous anti-climate change policy.

Carpooling with Heterogeneous Users in the Bottleneck Model

When drivers opt for carpooling, road capacity will be freed up, and this will reduce congestion. Therefore, carpooling is interesting for policy makers as a possible solution to congestion. We investigate the effects of carpooling in a dynamic equilibrium model of congestion, which captures various dimensions of heterogeneity: in preference for carpooling, ratio heterogeneity between the values of time and the values of schedule delay, and proportional heterogeneity that scales all values equally. We investigate three policy scenarios: no-toll, first-best pricing, and subsidization of carpooling. The optimal second-best subsidy equals each type’s heterogeneous marginal external benefit (MEB) of switching to carpooling. If such differentiation is impossible, the third-best subsidy is a weighted average of the MEBs, where the weights depend on the number of each type and their sensitivity to the subsidy. In our numerical example, we find that when increasing the degree of ratio heterogeneity, the relative efficiency of the second-best subsidization first increases and then falls with the degree of and L type carpoolers benefit more than H type carpoolers. However, when increasing the degree of proportional heterogeneity, H type users benefit more than L types for both solo drivers and carpoolers. Moreover, the relative efficiency of the second-best subsidization decreases throughout.

Second-Best Renewable Subsidies to De-carbonize the Economy: Commitment and the Green Paradox

Climate change must deal with two market failures: global warming and learning by doing in renewable energy production. The first-best policy consists of an aggressive renewables subsidy in the near term and a gradually rising and falling carbon tax. Given that global carbon taxes remain elusive, policy makers might have to rely on a second-best subsidy only. With credible commitment the second-best subsidy is higher than the social benefit of learning to cut the transition time and peak warming close to first-best levels at the cost of higher fossil fuel use in the short run (weak Green Paradox). Without commitment the second-best subsidy is set to the social benefit of learning. It generates smaller weak Green Paradox effects, but the transition to the carbon-free takes longer and cumulative carbon emissions are higher. Under first best and second best with pre-commitment peak warming is 2.1–2.3 ^{circ }C, under second best without commitment 3.5 ^{circ }C, and without any policy 5.1 ^{circ }C above pre-industrial levels. Not being able to commit yields a welfare loss of 95% of initial GDP compared to first best. Being able to commit brings this figure down to 7%.

Second-Best Renewable Subsidies to De-Carbonize the Economy: Commitment and the Green Paradox

Climate change must deal with two market failures: global warming and learning by doing in renewable use. The first-best policy consists of an aggressive renewables subsidy in the near term and a gradually rising and falling carbon tax. Given that global carbon taxes remain elusive, policy makers have to use a second-best subsidy. In case of credible commitment, the second-best subsidy is set higher than the social benefit of learning. It allows the transition time and peak warming close to first-best levels at the cost of higher fossil fuel use (weak Green Paradox). If policy makers cannot commit, the second-best subsidy is set to the social benefit of learning. It generates smaller weak Green Paradox effects, but the transition to the carbon-free takes longer and cumulative carbon emissions are higher. Under first-best and second best with pre-commitment peak warming is 2.1 - 2.3 °C, under second best without commitment 3.5°C, and without any policy temperature 5.1°C above pre-industrial levels. Not being able to commit yields a welfare loss of 95% of initial GDP compared to first best. Being able to commit brings this figure down to 7%.

Renewable energy subsidies: Second-best policy or fatal aberration for mitigation?

This paper evaluates the consequences of renewable energy policies on welfare and energy prices in a world where carbon pricing is imperfect and the regulator seeks to limit emissions to a (cumulative) target. The imperfectness of the carbon price is motivated by political concerns regarding distributional effects of increased energy prices. Hence, carbon prices are considered to be temporarily or permanently absent or endogenously constrained by their effect on energy prices. We use a global general equilibrium model with an intertemporal fossil resource sector and calculate intertemporally optimal policies from a broad set of policy instruments including carbon taxes, renewable energy subsidies and feed-in-tariffs, among others. If carbon pricing is permanently missing, mitigation costs increase by a multiple (compared to the optimal carbon pricing policy) for a wide range of parameters describing extraction costs, renewable energy costs, substitution possibilities and normative attitudes. Furthermore, we show that small deviations from the second-best subsidy can lead to strong increases in emissions and consumption losses. This confirms the rising concerns about the occurrence of unintended side effects of climate policy – a new version of the green paradox. Smart combinations of carbon prices and renewable energy subsidies, however, can achieve ambitious mitigation targets at moderate additional costs without leading to high energy price increases.

International Cooperation on Climate-friendly Technologies

We examine international cooperation on technological development as an alternative to international cooperation on emission reductions. We show that without any R&D cooperation, R&D in each country should be increased beyond the non-cooperative level if (i) the technology level in one country is positively affected by R&D in other countries, (ii) the domestic carbon tax is lower than the Pigovian level, or (iii) the domestic carbon tax is set directly through an international tax agreement. We also show that a second-best technology agreement has higher R&D, higher emissions, or both compared with the first-best-outcome. The second-best subsidy always exceeds the subsidy under no international R&D cooperation. Further, when the price of carbon is the same in the second-best technology agreement and in the case without R&D cooperation, welfare is highest, R&D is highest and emissions are lowest in the second-best R&D agreement.

Renewable Energy Subsidies: Second-Best Policy or Fatal Aberration for Mitigation?

This paper evaluates the consequences of renewable energy policies on welfare, resource rents and energy costs in a world where carbon pricing is imperfect and the regulator seeks to limit emissions to a (cumulative) target. We use a global general equilibrium model with an intertemporal fossil resource sector. We calculate the optimal second-best renewable energy subsidy and compare the resulting welfare level with an efficient first-best carbon pricing policy. If carbon pricing is permanently missing, mitigation costs increase by a multiple (compared to the optimal carbon pricing policy) for a wide range of parameters describing extraction costs, renewable energy costs, substitution possibilities and normative attitudes. Furthermore, we show that small deviations from the second-best subsidy can lead to strong increases in emissions and consumption losses. This confirms the rising concerns about the occurrence of unintended side effects of climate policy - a new version of the green paradox. We extend our second-best analysis by considering two further types of policy instruments: (1) temporary subsidies that are displaced by carbon pricing in the long run and (2) revenue-neutral instruments like a carbon trust and a feed-in-tariff scheme. Although these instruments cause small welfare losses, they have the potential to ease distributional conflicts as they lead to lower energy prices and higher fossil resource rents than the optimal carbon pricing policy.

International Cooperation on Climate-Friendly Technologies

We examine international cooperation on technological development as a supplement to, or an alternative to, international cooperation on emission reductions. R&D should be increased beyond the non-cooperative level if (i) the technology level in one country is positively affected by R&D in other countries, (ii) the domestic carbon tax is lower than the Pigovian level, or (iii) the domestic carbon tax is set directly through an international tax agreement. A second-best technology agreement has higher R&D, higher emissions, or both compared with the first-best-outcome. The second-best subsidy always exceeds the subsidy under no international R&D cooperation. Further, when the price of carbon is the same in the second-best technology agreement and in the case without R&D cooperation, welfare is highest, R&D is highest and emissions are lowest in the second-best R&D agreement.

Subsidies to Higher Education and Income-Tax Progression

The impact of fiscal activity on human-capital formation has often been analyzed with regard to the expenditure side of the budget; i.e., the subsidization of (higher) education. However, recent contributions have increasingly focused on the effect of taxation on human-capital formation. Less attention has been given to the simultaneous effect of both subsidization and taxation. as subsidies to higher education may offset the distortionary effect of taxation, this paper aims to analyze the amount of subsidization that is necessary to counteract the discouraging effect of various kinds of income-tax progression on human-capital accumulation. An important policy advice derived from the analysis is that a country's educational policies should be evaluated, not just by the levels of educational spending, but also by the level and structure of taxation. The framework we use to illustrate our point is a two-period cohort model with heterogeneous agents, who endogenously decide on higher education with respect to taxation and subsidization. in this framework, we also demonstrate that subsidies may fail to offset existing tax distortions, limiting the optimistic view of some previous literature. in particular, we show that a second-best subsidy rate must be lower than unity. Otherwise an optimal subsidy rate leads to the problem of overeducation.