Carbon Abatement in the Fuel Market with Biofuels: Implications for Second-Best Policies

A carbon tax would penalize carbon intensive fuels like gasoline and shiftfuel consumption to less carbon intensive alternatives like biofuels. Since biofuelproduction competes for land with agriculture, a carbon tax could raiseland rents, divert land towards fuel production, and raise agricultural prices.This paper analyzes the welfare effect of a carbon tax on fuel with gasolineand biofuel as available fuel choices, in the presence of a labor tax and biofuelsubsidy. The second-best optimal carbon tax is also quantified. Findings showthat when biofuels is part of the fuel mix, the carbon tax has a commodityprice effect which arises from tax-induced changes in land rent. The commodityprice effect could exacerbate or attenuate the tax interaction effect causedby higher fuel prices, depending on the elasticity of substitution between gasolineand biofuel, the price elasticity of miles demand, and the relative emissionsintensity of gasoline and biofuel. Numerical results show that the commodityprice effect affects the value of the second-best optimal carbon tax, and thatthe effect is greater if the elasticity of substitution between gasoline and biofuelis high, miles is more price inelastic, and the GHG intensity of biofuel is lowercompared to gasoline. In addition the existence of a fixed biofuel subsidy leadsto a greater divergence between the value of the second-best optimal carbontax with or without biofuels. A carbon tax policy decreases GHG emissionsand increases welfare, in contrast to a biofuel subsidy, which also decreasesGHG emissions but at a net welfare loss.