Carbon Taxes and Green Subsidies in a World Economy

Abstract We examine positive and normative questions that arise with the joint use of carbon taxes and green subsidies in an open economy. Moving from autarky to free trade induces countries to introduce green subsidies and reduce carbon taxes, in order to reduce foreign emissions. In contrast to the “leakage” effect of carbon taxes, green subsidies are associated with “reverse leakage,” as they decrease emissions both at home and abroad, and as a consequence, the availability of green subsidies tends to be good for global welfare. International climate agreements (ICAs) seek to increase carbon taxes, but the effect on green subsidies is more nuanced. An ICA removes green subsidies, even though they exert positive international externalities at the noncooperative equilibrium. If, however, policies can only be changed gradually, an ICA may start by increasing subsidies before decreasing them over time. We also consider the welfare implications of lobbying from the fossil and green energy sectors. In a noncooperative setting, we find that pressures from the fossil lobby tend to reduce welfare, whereas pressures from the green lobby tend to increase welfare. We also find that in the presence of lobbying, an ICA can decrease welfare relative to the noncooperative equilibrium, even if it changes carbon taxes and green subsidies toward their efficient levels.