How significant are fiscal interactions in climate policy design? A CGE analysis

A major challenge facing policy makers in climate policy design is how to reduce greenhouse gas emissions at the lowest cost to the economy. The interactions of climate change policies with the tax system become relevant in this context. This paper investigates these interactions, by analyzing the impacts, both at the macroeconomic and sectoral levels, of the distinct redistribution of carbon tax revenues to the economy. To this end, numerical simulations with a hybrid computable general equilibrium model (HyBGEM) are performed. Results indicate that the whole economic impacts of a carbon tax are largely dependent on the fiscal revenue recycling mechanism chosen. A well-designed carbon tax could play a significant role in addressing the challenges posed by climate change mitigation at the least cost to the economy. In a distorted economy like Portugal, there is no efficiency gain in using carbon tax revenues to cut pre-existing distortionary taxes.