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An Innovative Source of Development Finance

The Carbon Tax

by Nitin Desai

With official development assistance falling short of needs, there has long been a search for ‘innovative’ means for financing development. Over the years, a wide range of proposals has been made, but few have been put into practice.

Carbon taxes are one of the leading ideas that have been put forward. They have engendered a strong following and were advocated by a respected international commission headed by former Mexican president Ernesto Zedillo in 2002. Proponents see carbon taxes as having multiple benefits:

First, carbon emissions (and other greenhouse gases) are widely accepted as having deleterious effects. These harms apply not only to the global commons, but are also monetarily significant because of the impact on productivity. A tax should reduce such emissions and losses.

Carbon taxes encourage the search for new energy sources. ©  Lehtikuva / Chad Ehlers
Carbon taxes encourage the search for new energy sources. © Lehtikuva / Chad Ehlers

​Second, these costs are caused primarily by the users of fossil fuels, but not borne by them. Instead, they become economic externalities, with the costs diverted to society at-large. An appropriately assessed tax would internalize the externalities and force producers to account for the full cost of production. On a related point, advocates claim that a carbon tax not only encourages emitters to abate, but is also a spur to innovation because it encourages a search for cost-effective means of reducing emissions (in order to avoid the tax).

Finally, carbon taxes have been seen as a means to mobilize development finance. Revenue from carbon taxes could be significant, especially in countries with a large energy sector dominated by carbon-high fuels. Whether these revenues would be available, in full or in part for development finance is a moot question. Moreover to the extent to which the tax succeeds in its primary objective of reducing emissions, the generation of revenue would clearly be lower than current levels of emissions would indicate.

Carbon taxes have received significant coverage and support, most recently as a result of the 1997 Kyoto Conference. To many, they represent one of the prime elements in a widespread movement towards ‘greener’ tax codes and they have been introduced in the Netherlands and some Nordic countries. Despite this support, there remain key questions about implementing the tax on the global scale that most advocates deem desirable.

The first question relates to the local and international political realities of the tax. Local agreement on new ‘green’ taxes (like carbon taxes) has often been won with a promise that such a move will be revenue neutral - that new taxes on carbon (and other environmental ills) will be offset by the elimination or reduction of other existing taxes. Such an approach on a generalized carbon tax would not provide the desired additional funds for developmental purposes. At the global level, it is not at all clear that a nationally levied and collected tax would be available for global purposes. Even if such taxes are based on a global agreement which includes provisions to this effect, the task of deciding how the revenue earned from such an international tax should be used would also be politically complex.

The second question concerns the effect of the tax on output. Some observers have balked at carbon taxes because of the impact that forcible limitations on emissions may have on economic growth. Because fossil fuels are such a crucial input in global production, the concern is that a curtailment of their use (due to their higher effective cost under a tax) would reduce global output and therefore overall well-being. However, this relationship may not be as direct as many claim.

For those who do not foresee the development of any substitute technologies the impact of holding emissions constant at a 1990 level could lead to substantial annual losses. But such an assumption is unrealistic. When prices change we can expect some substitutions to take place. Adopting more positive assumptions (such as the efficiency of economic responses, the development of substitute fuels/ methods, etc.), could even have a net increase of 2.3 per cent of GDP with the same restrictions on carbon usage. Regardless of the impact on production, some observers argue that a trading system for pollution permits might be more effective than a tax in limiting emissions and more politically acceptable.

A third major concern is how any harmful effects of carbon taxes could be limited. For example, many authors have examined the redistributional effects of a carbon tax on the household. One finding has been that a carbon tax is regressive because low-income families tend to spend a higher proportion of their incomes on energy-related products. Additionally, forcing carbon abatement may encourage the development of production techniques that emit other harmful gases. Carbon represents only 60 per cent of the greenhouse gases and the other gases (such as CH4 , N2 O, HFCs, PFCs, SF6 ) are also environmentally deleterious, significantly harder to measure and largely untouched by the carbon tax.

Finally, the competing demands of the tax’s main proponents— environmentalists and development practitioners—are difficult to reconcile. The groups are at cross purposes in one key respect: advocates wishing to raise money for development would like to see significant carbon emissions remain so as to earn money from the tax whereas environmentalists would prefer the tax to reduce carbon emissions (resulting in a decline in the corresponding tax revenues). A possible reconciliation between the two groups is that emissions would subside as a result of a tax and the costs of global warming mentioned above would be reduced. Theoretically, the resources thus saved could be earmarked for development. However, the ‘savings’ would be only implicit and it would likely be difficult to convince policy makers to necessarily allocate those funds to global development purposes.

Carbon taxes are under active discussion in policy analysis circles. However, the view taken in intergovernmental discussions is much more cautious. In the ‘Monterrey Consensus’ adopted by the International Conference on Financing for Development in March 2002, governments agreed to study an analysis of possible innovative sources of financing. WIDER has been requested by the UN to undertake this analysis and carbon taxation will be one of the items addressed. There will be a preliminary discussion of the findings of this WIDER/UN project in September 2003, with the final results expected to be published in 2004. An invigorated international debate on the subject is expected to ensue.

During his tenure as UnderSecretary-General at UN Headquarters in New York, Nitin Desai has been in charge of most of the UN’s ‘global conferences’, as well the major five-year reviews that have often followed. This impressive record started with his appointment as Deputy-SecretaryGeneral of the UN Conference on Environment and Development that took place in Rio de Janeiro in 1992. In 2002, as Under-SecretaryGeneral for the UN’s Department of Economic and Social Affairs, he oversaw the International Conference on Financing for Development and the World Summit on Sustainable Development.

This article is written with the substantive assistance of Adam M. Smith, Economic Affairs Officer, UN/DESA.

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