Carbon taxes and their effects on inequality

What are the distributional effects of climate policies? And how can such policies, for example carbon taxes, be designed to avoid or compensate any negative effects that would increase inequality? Professor Armon Rezai from WU’s Institute for Ecological Economics has taken a closer look at how climate policies can affect inequality in a detailed study on the situation in Germany.

Taxing carbon emissions creates inequality because low-income households are hit harder. However, the overall effects of such measures depend on how revenues from such taxes are spent, says WU Professor Armon Rezai. It is the declared goal of EU climate policy to make the Union carbon-neutral by 2050. This is necessary for limiting global warming to an average of 2 degrees Celsius or less. So far, climate policies have focused primarily on reducing the carbon emissions produced by power plants, industrial enterprises, and fossil fuels. To meet the 2-degree target, however, it is necessary to address all sources of carbon emissions. Recent moves to step up political efforts for achieving the 2-degree goal have met with resistance, however. One example is the yellow vests movement in France, whose fierce protests forced the French government to step back on its climate policies and its ambitious plans for taxing carbon emissions.

The effects of carbon taxes

In a study based on comprehensive data collected in Germany, WU Professor Armon Rezai has shown that the financial effects of carbon taxes on different households can vary considerably. Surprisingly, the research shows that the much-touted divide between urban and rural areas plays only a secondary role in this context. The level of revenues gained from carbon taxes may be relatively small compared to other taxes, but the details of how these revenues are spent determine who benefits and who loses. In Canada and Switzerland, for example, revenues from carbon taxes are refunded to the people on a per-capita basis, which helps to lower inequality. Another option is cutting existing taxes instead.

This approach is referred to as green tax reform. It has the potential to reduce the overall cost of climate policy significantly. However, the green tax reform approach tends to favor richer households because they benefit more from the tax cuts. The recent decisions by EU member states to strengthen their climate policies mark an important milestone. Whether it will be possible to ensure widespread acceptance of these policies will largely depend on some key details, e.g. the use of the new tax revenues. In the coming years, the question of how these revenues should be spent will be the subject of intense political debates in the EU and other industrialized economies.