01 Feb 2006

Environmental Policy Competition and Differential Tax Treatment

A Case for Tighter Coordination?

Richard Nahuis / Paul J. G. Tang

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European Network of Economic Policy Research Institutes (ENEPRI) Working Paper No. 42, 26 pages

The Kyoto Protocol binds the level of greenhouse gas emissions in participating countries. It does, however, not dictate how the countries are to achieve this level. The economic costs of reaching emission targets are generally evaluated to be low. For example, evaluations with applied general-equilibrium models estimate the costs to be in the range of 0.2% to 0.5% of GDP, when international trade in emissions rights among governments is allowed for. We argue that important costs are overlooked since governments are inclined to choose highly distorting tax schemes. This paper shows that governments generally choose different energy tax rates for households and for internationally operating firms as the result of tax competition or pollution competition: in the first case, governments try to undercut other governments to attract firms to their country, whereas in the second, they try to push dirty industries across the border. In both cases, the incentive for firms and households to use or save energy is different at the margin. Both cases call for co-ordination of climate change policies that goes beyond a binding ceiling on greenhouse gas emissions and international trade in permit rights among governments alone.