I thank the Chairman for the invitation to appear before the committee. I am head of the climate economy modelling team at the ESRI, and I am accompanied by my colleague, Dr. John Curtis. This committee is considering the budgetary implications of issues relating to climate change. The specific design of a climate policy will have ramifications for its environmental, economic, distributional and budgetary impacts. It is critical that policies are well designed to ensure emissions reductions, minimise the economic disruption and be distributionally fair whereby those most able to bear the costs do so.
In this opening statement, I will give the committee an outline of the current work being conducted at the ESRI on the carbon tax and convey our results concerning this issue. Our goal is to provide insights into the impacts of increasing the tax to guide policy formation. I will focus on our results concerning the increased revenue resulting from a carbon tax increase, the impacts on emissions, macroeconomic impacts and distributional impacts across production sectors and households.
To contextualise our results, a general understanding of our methods is useful, hence I will first give a short non-technical overview of our model. The Ireland, Environment, Energy and Economy, I3E, model has recently been developed by Dr. Aykut Mert Yakut and I. It examines the relationship between the economy, energy use and the emissions of greenhouse gases.
In technical terms, it is a macroeconomic intertemporal computable general equilibrium model, which reproduces the structure of the economy in its entirety. It includes 32 distinct production sectors, 37 different goods, ten households types, three labour types, trade and the government, among others. It is a dynamic model, which incorporates economic growth over a modelling horizon that runs from 2014 to 2050. Under the model, the nature of all existing economic transactions among diverse economic agents is quantified. It examines how inputs and outputs flow between production sectors of the economy and result in final goods consumed by households. The I3E model includes energy flows and emissions in addition to the standard monetary flows.
Each production sector produces an economic commodity using labour, capital, material inputs and energy inputs. The I3E model explicitly comprises a set of carbon commodities, including peat, coal, natural gas, crude oil, fuel oil, LPG, gasoline, diesel, kerosene and other petroleum products. Based on relative prices, producers can change their production inputs to minimise costs. Similarly, consumers can change their consumption patterns based on relative costs to maximise their utility. The explicit modelling of intersectoral linkages makes it possible to investigate the wider economic impacts of a specific policy, such as a carbon tax, through the different transmission channels in the economy. We examine the impacts of an increase in the carbon tax of €10 in 2020 with further increases of €5 a year after that reaching a carbon tax of €80 in 2030.
I will first focus on the case where carbon tax revenues are used to reduce Government debt. After that, I will discuss our investigation of different revenue recycling schemes to understand how carbon tax revenue can be used to limit the economic and distributional impacts of the carbon tax increase. Increasing the carbon tax by €10 in 2020 would increase expected carbon tax revenue from €459 million to €666 million in 2020 and the additional increments in the tax would increase carbon revenues from €682 million to €2.138 billion in 2030. However, when this carbon tax revenue is not recycled but used to reduce Government debt, our model shows that revenue impacts are likely to be negative, where large decreases in the receipts of sales taxes, wage taxes and corporate taxes, due to decreased economic output and consumption, outweigh the increase in carbon tax receipts.
Household emissions are estimated to decrease, on average, by 10% in 2030 compared to no increase in carbon tax. These results are in line with other ESRI work, which develops a behavioural microsimulation model and econometrically estimate the behavioural response of households to a carbon tax increase in terms of direct carbon emissions. We find that rural households reduce their emissions substantially more than urban. Economy-wide emissions in 2030 are estimated to be 15% lower with the carbon tax increase then without it. Over time, however, emissions still increase, with 2030 emissions almost 27% higher than 2018 emissions. Our model is likely to underestimate emission reduction as we do not explicitly include new technologies in the model, though it is clear that in absence of other climate policies, the carbon tax would need to be significantly higher to reach the Irish EU emission targets.
Real GDP will be lowered by 0.3% in 2020 compared to no increase in tax and will be 0.6% lower in 2030. Wages will decrease, where low-skilled labour is impacted most. The most impacted production sectors are transport, mining and electricity with value added reductions of up to 2.7%, compared to a situation where there is no increase in the carbon tax. Comparing impacts across households, we find a strong regressive trend, where poorer households are impacted the most in terms of disposable income, consumption, price increases and welfare. In terms of welfare, rural households are impacted more than urban. This is in line with the findings of Tovar Reanos and Lynch, as well as other ESRI work which applies the ESRI’s tax and benefit microsimulation, SWITCH, model, which replicates the tax and benefit system of Ireland in a high level of detail.
The Ireland Environment, Energy and Economy, I3E, model finds higher impacts, as it includes secondary impacts such as price changes to non-carbon goods, macro-economic impacts and household income impacts via wage and capital income.
A major concern about a carbon tax is that it is often regressive in nature. We see the same effect in Ireland. Distributing carbon tax revenues to households is often proposed as an effective way of reducing the regressive aspects of the tax. We have examined two transfers schemes to see what the impact might be. Under the first, carbon tax revenues are given back to households on a per capita basis. Under the second, revenues are distributed based on relative current welfare transfers. In terms of real disposable income, a lump sum transfer would significantly decrease the regressive trend of the tax, having positive impacts for rural households and negative impacts for urban households. Applying a transfer based on social welfare, we find a decrease of a lesser degree in regressiveness. Both Tovar Reanos and Lynch and Bercholz and Roantree, in their respective studies, find such transfers to have a higher impact in reducing regressive trends. Our results show that the secondary impacts of these distribution schemes - predominantly changes in wage and capital income - are regressive. Real GDP impacts remain negative, but they are almost halved when compared to when revenue is used to reduce Government debt. When applying social welfare or lump sum transfers, net Government revenue is estimated to increase by approximately €500 million in 2020.
It is often suggested the revenues from an environmental tax may be recycled to create a so-called double dividend, whereby other distortionary taxes can be reduced and economic growth boosted, while, at the same time, achieving emissions reductions. We have investigated various revenue recycling schemes and their impact on the economy, as well as their distributional impacts across households. Our results show that when carbon tax revenue is used to reduce other distortionary taxes in the economy, a double dividend can be achieved. Decreasing wage taxes, sales taxes or corporate taxes will result in an increase in GDP of up to 0.8% compared with no change in carbon tax, while still achieving significant emissions reductions. The impact on households will be positive, but it will have higher positive impacts on richer households. Value added in most sectors is boosted and value-added reductions are limited in carbon tax sensitive sectors, with the exception of transport.
If carbon revenue was to be used to reduce sales taxes, it would increase wage and corporate tax receipts owing to increased consumption, giving an increase in total Government revenues of approximately €660 million in 2020. Reducing wage taxes would boost production and receipts of sales taxes and corporate taxes, resulting in an approximate increase in total Government revenues of €1.6 billion in 2020. A reduction in corporate taxes would increase receipts of wage and sales taxes, thereby increasing total Government revenues by €1.3 billion and reducing more Government debt than when revenues are used directly to reduce Government debt.
We have found that the economic and budgetary impacts of a carbon tax will strongly depend on the policy design. A well designed carbon tax revenue recycling scheme can assist in reaching other policy goals such as economic growth and inequality reduction, in addition to emissions reduction. We wish the committee every success in its work and will be happy to assist members in the coming months.